The Rationale for the Charting Method

The Rationale for the Charting Method

Probably the hardest question to answer is: Why is charting supposed to work? Some of my best friends are chartists and I listened very carefully to their explanations, but I have yet really to understand them. Indeed, many chartists freely admit that they don’t know why charting should work – history just has a habit of repeating itself. Even Magee, the chartist seer, went so far as to say that we can never hope to know “why” the market behaves as it does, we can only aspire to understand “how”.

According to Magee, the situation in the stock market is analogous to that of a pig in a barn. The barn is all closed up on the ground floor, but it has a hayloft above with a large open door. The pig has a harness around his body to which is attached a long pole, the top of which is visible through the hayloft door. Of course, when the pig moves about, so will the pole. Magee supposed that we are perched in a nearby tree observing the motions of the top of the pole, which is all we can see.

We must deduce from the pole’s movement what is happening below, just as market participants must deduce what is happening in the market from the price movements they can observe. Magee went on to say that it is not important to know the color of size of the pig, or even whether it is a pig at all; it is only important to be able to make predictions about the next movement of the pole.

Behaviour is the mirror in which everyone shows their image (Johann Wolfgang von Goethe). Photo by Elena.

Some of the watchers who are not comfortable with highly abstract symbols will assign “meanings” to the pole’s movements. They will try to “interpret” these movements as corresponding to various assimilative, combative, copulative, etc., actions of the pig. Others (like Magee, the author), who might consider themselves “pure technicians,” will watch the pole, and work entirely on the basis of what the pole has done, is doing, or might be expected to do according to trends, repetitive motions, extrapolations, etc.Yet it is in our nature to ask why. To me, the following explanations of technical analysis appear to be the most plausible. Trends might tend to perpetuate themselves for either of two reasons. First, it has been argued that the crowd instinct of mass psychology makes it so. When investors see the price of a speculative favorite going higher and higher, they want to jump on the bandwagon and join the rise. Indeed, the price rise itself helps fuel the enthusiasm in a self-fulfilling prophecy. Each rise in price just whets the appetite and makes investors expect a further rise.

Seond, there may be unequal access to fundamental information about a company. When some favorable piece of news occurs, such as the discovery of a rich mineral deposit, it is alleged that the insiders are the first to know and they act, buying the stock and causing its price to rise. The insiders then tell their friends, who act next. Then the professionals find out the news and the big institutions put blocks of the shares in their portfolios. Finally, the poor slobs like you and me get the information and buy, pushing the price still higher. This process is supposed to result in a rather gradual increase in the price of the stock when the news is good and a decrease when the news is bad. Chartists claim that this scenario is somewhat close to what actually happened in the notorious Texas Gulf Sulphur case, where insiders profited on the basis of nonpublic information. Chartists are convinced that even if they do not have access to this inside information, observation of price movements alone enables them to pick up the scent of the “smart money” and permits them to get in long before the general public.

Chartists believe that another reason their techniques have validity is that people have a nasty habit of remembering what they paid for a stock, or the price they wish they had paid. For example, suppose a stock sold for about $50 a share for a long period of time, during which a number of investors bought in. Suppose then that the price drops to $40.

The chartists claim that the public will be anxious to sell out the shares when they rise back to the price at which they were bought, and thus break even on the trade. Consequently, the price of $50 at which the stock sold initially becomes a “resistance area.” Each time the resistance area is reached and the stock turns down again, the theory holds that the resistance level becomes even harder to cross, because more and more investors get the idea that the market or the individual stock in question cannot go any higher. A similar argument lies behind the notion of “support levels.” Chartists say that many investors who failed to buy when the market fluctuated around a relatively low price level will feel they have missed the boat when prces rise. Presumably such investors will jump at the chance to buy when prices drop back to the original low level.

Chartists also believe that investors who sold shares when the market was low and then saw prices rise will be anxious to buy those shares back if they can get them again at the price for which they sold. The argument then is that the original low price level becomes a “support area,” since investors will believe that prices will again rise above that level. In chart theory, a “support area” that holds on successive declines becomes stronger and stronger. So if a stock declines to a support area and then begins to rise, the traders will jump in believing the stock is just “coming off the pad.” Another bullish signal is flashed when a stock finally breaks through a resistance area. In the lexicon of the chartists, the former resistance area becomes a support area, and the stock should have no trouble gaining further ground.

Burton G. Malkiel. A Random Walk Down Wall Street, including a life-cycle guide to personal investing. First edition, 1973, by W.W. Norton and company, Inc.

The deepness of the finance is darker than insondable deepness of the Cosmos. Illustration by Elena.