Technical Analysis: Market Psychology Indicator

Includes: DIA, QQQ, SPY
by: Leigh Drogen

I meet a lot of interesting characters these days. Sometimes it’s Hungry Web Entrepreneur, other times Loud Money Manager. I cross paths with Social Media Douchebag quite a bit, and of course being a young man living in New York City, I meet a lot of Desperate Jewish Girls. Today though, I sat down with Joe Retail Investor who wanted to know about what type of trader I am.

Joe Retail Investor: A friend told me that you were a pretty good trader, what’s your strategy Leigh?

Leigh: Well I normally describe myself as using technical analysis backed up by fundamentals and a broader macro economic view.

Joe Retail Investor: Technical analysis, really? I thought you were a serious trader, my friend spoke pretty highly of you.

Leigh: Well please thank your friend for the kind words, but I’m not quite sure what you mean?

Joe Retail Investor: Isn’t technical analysis for lazy day traders who don’t really know much about the market? I’ve been taught all my life that you want to invest in companies with solid fundamentals, which have good growth prospects, and look cheap. I’ve never heard of a big successful money manager who primarily uses technical analysis as his strategy.

Leigh: Well, I’m not quite sure where you learned your investing strategy, by the way, where did you learn your investing strategy?

Joe Retail Investor: I watch CNBC a lot at work so I’ve learned from the money managers that are interviewed on there, some smart guys huh.

Leigh: Yea smart guys. So how do you decide when to sell a stock?

Joe Retail Investor: When the fundamentals change of course; my sell side analyst tells me when to sell stuff. Wait, how did this get to be about me, how are people possibly trusting you with their money when you trade based off of technicals, I’ve heard that’s all just a bunch of baloney.

Leigh: Well I’m glad you listen to your analyst, I’m sure he’s done a good job at managing risk for you.

Joe Retail Investor: Wait, what’s managing risk?

Leigh: Let’s skip that for now, why don’t I answer your previous question. In fact a lot of great traders use technical analysis, even as a primary strategy, some great traders use technical analysis only. Yes, there are a lot of lazy people out there who attempt to become day traders and try to take shortcuts by thinking they can succeed by using technical analysis, but I promise you, about 95% of those people fail pretty quickly. There are no shortcuts when it comes to making money in the market, and reading a book on technical analysis is no different.

Joe Retail Investor: But isn’t technical analysis just a religion, it’s one of those things that only works if everyone thinks it’s real. Is there anything real about technical analysis, I know when a company is cheap, can you tell when a stock is cheap based on the technicals?

Leigh: Well, no, that’s not really the point of technical analysis, and no, technical analysis isn’t just a religion. Here’s what technical analysis is. Because people are the ones buying and selling assets in the market, or writing the algorithms which buy and sell assets for them, asset prices will always be subject to the fallibility of human emotions. Certain emotions in the market represent themselves by certain price and volume patterns, the same patterns have existed since the beginning of the market, and they will exist until the market is gone. Why? Because human emotions don’t change. The name of stocks change, the fundamentals of companies change, but human emotions never will, and the chart is the representation of that emotion. So when I look at a chart, and call it technical analysis, what I’m really looking at is the collective psychology of all market participants for that asset.

Joe Retail Investor: Do you have a PHD in psychology?

Leigh: No, I don’t. You don’t need a PHD in psychology to understand how and why market participants react the way they do to certain movements in a an asset, along with the fundamental news about that asset. Almost all traders and investors use some kind of market sentiment analysis in their strategies, even the guys who use deep value strategies and have their heads buried in balance sheets all day. Have you ever felt that a stock’s price had gone down too much too fast and was likely to bounce?

Joe Retail Investor: Sure, I love to buy companies that have had their stock prices hit recently, it presents an opportunity to buy the stock on the cheap.

Leigh: Well, I wouldn’t necessarily agree with that, but you are doing technical analysis, you just don’t know it. The fact that you believe a stock has gone down too much too fast and is likely to rebound in the short term is a type of technical analysis, we call it mean reversion, or being too far away from a moving average.

Joe Retail Investor: Yea, but what about all of those silly patterns I hear about? Or this support and resistance thing, don’t these things only exist because other traders are looking at them?

Leigh: Those “silly patterns” are nothing more than the psychology of the market at work. Certain patterns in investor and trader buying and selling activity create repeatable patterns in price and volume. Although the same patterns have existed since the beginning of the market, they aren’t iron clad, it isn’t a science, it’s more of an art. Think of it this way, if you play tennis against a friend over and over, you’ll eventually come to understand patterns in his shot selection. If you hit a cross court backhand deep to his backhand, you might know that he’s very likely to return that ball cross court to your backhand. You’d only know that if you studied his play for quite a while, and when you were comfortable with your intuition that the pattern would repeat itself under certain circumstance, you might decide to position yourself early to take advantage of his shot, run around to your forehand, and crush the ball down the line. Well, we do the same thing in the market. When we see a pattern that we recognize with a high probability of moving in a certain direction, we position ourselves to take advantage of it.

Joe Retail Investor: So you’re saying you know where the price is going? I just can’t believe that.

Leigh: I didn’t say I knew where the price was going, I’m saying that I’ve got a rough estimate of the probability of which direction and at what rate the price will move over a certain period of time. I think about the market in terms of risk vs reward, and the patterns that I recognize allow me to only buy or short stocks which give me the best chances of success.

Joe Retail Investor: OK so maybe you have some kind of short term strategy that works, but I don’t trade stocks daily, I want to hold my positions for months or even years. How can technical analysis possibly help me?

Leigh: Technical analysis is useful on all time frames. But here’s how it can help you specifically if you’re an investor who likes to buy stock in companies who have had their share prices beaten down recently, and where you believe there is good value.

There’s this idea in technical analysis called support and resistance. What these support and resistance areas represent are levels at which traders and investors have shown willingness to either buy or sell stock in that company. So if you’re a value investor and you’ve decided that a good price to buy that stock is $30, you are likely to buy shares of that stock when it hits that price, over and over again, as you believe there is good value. Well, what we look at as technical analysts is where all market participants believe there exists a good value for that stock, and it is represented by price levels at which there is a lot of activity over a period of time. We believe that if in the past traders and investors were willing to buy a lot of stock at that level, then it’s likely that they will do the same this time around.

The same goes for selling a stock, if a stock has been sold consistently at a certain price over time, then it’s likely that it’s sold again at that price this time around. So how can this help you? Well, if you’re looking to buy a stock that is getting hit in price, it’s best to find a level of support at which the stock has been bought in the past, and set your buy order there. There’s no sense in buying it before that support level, as it’s likely that the stock keeps moving down until it gets to the point where investors have decided to buy it in the past.

Joe Retail Investor: So you’ve told me about how I can use technical analysis to buy stocks, but how about selling them. I use my sell side research analyst to tell me when to sell the stock.

Leigh: That depends on what type of trader or investor you are, once again. But if you’re a long term investor, there are two ways you should be using technical analysis to tell you when to sell. The first is when the price of the stock moves against you and you need to take a loss on the position.

Joe Retail Investor: Take a loss, I never take a loss, I average down on my positions.

Leigh: Oyyy, while it’s OK to collect shares in a stock at certain levels, you’ve got to know how to manage your risk, even when you have conviction in the fundamentals of a company. You can use technical analysis to determine the probability that a stock keeps falling, when it’s broken all of it’s major support levels and remains in a downtrend below all of it’s major moving averages, it’s not smart to be long the stock on a long term time frame. Technical analysis is about risk management first and foremost. When you’ve got a position that shows you a profit, you can use technical analysis to get you out of the position by using resistance levels and moving averages as well.

Joe Retail Investor: OkK so maybe I can incorporate some of this in my investing methods, but what’s your strategy, you still haven’t told me.

Leigh: Well, I operate on the intermediate term time frame. After scanning a universe of stocks for certain fundamental characteristics, I look for relative strength in price and patterns that I recognize on the daily time frame. I like to buy stocks that are trending nicely above their rising 20 and 50 day moving averages, and good risk reward entries to the trend based on those patterns. I also use my macro view to weight my portfolio in certain sectors, industries or asset classes. Another aspect of my trading revolves around the broader market because after all, 60% of a stock’s price movement is dependent on the overall market.

So if the market as a whole is not healthy, or showing technical strength, it doesn’t make much sense to be buying any stocks. Think about 2008 when there were still plenty of fundamentally sound stocks. They all got slaughtered because the market as a whole got slaughtered. You could have avoided taking major losses on your positions by selling stock when the technicals deteriorated.

Joe Retail Investor: OK, I’m starting to understand this a little, and although it still sounds a little confusing it does make some sense.

Leigh: Look, trading or investing based on technical analysis is just like any other kind of investing, there is no shortcut. Over time, just as you would develop a deep understanding for a company’s fundamentals and when you felt it was cheap, you can develop a deep understanding for how the price and volume of a stock or the market as a whole moves. It takes years and years to become comfortable trusting your intuition when you recognize a pattern that has worked for you in the past.

Joe Retail Investor: So what are your fees, maybe I’ll give you some of my money to manage.

Leigh: I don’t want your money.