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TheStreet Open House

Stock Analysis 101: Technical Analysis

BALTIMORE ( TheStreet) -- It shouldn't come as a surprise that investing elicits strong emotions among its practitioners -- after all, people's money is on the line. But few topics have drawn the same degree of ire and praise that technical analysis has. Today, we'll seek to bust technical analysis myths by shining a pragmatic light on this investing discipline.

Clearly, an exhaustive debate about the usefulness of technical analysis (or fundamental analysis, for that matter) is far more involved than could ever be achieved in a single article. That said, I'll attempt to scratch the surface, debunking some of the more prevalent myths in the technical analysis world.

First, though, let's define exactly what technical analysis is: At its core, technical analysis is the study of the market itself, rather than the goods that trade in the market, in determining the investment-worthiness of a security. While fundamental analysts worry about a company's business attributes, technicians are primarily concerned with price and volume and with the supply and demand attributes that impact shares.

With that definition in mind, let's take a look at some of the biggest myths:

Myth 1: Past Prices Aren't Useful for Predicting Future Prices

One of the most biting criticisms of technical analysis is the idea that there's no way past prices can be a crystal ball for future prices. It's that fact that makes looking at a chart for predictive value akin to reading tealeaves.

But that argument is seriously flawed. Anyone who's ever bought a stock can attest to the psychological impact of watching a position's gains climb or losses mount. That's a good indicator that entry prices do have an impact on future behavior. Remember, those entry prices are past prices. Because investors' entry prices have a lot to do with their eventual decisions to close their positions (or buy more), it's naive to think that past prices don't have some impact on how a stock trades in the future.

It's not that past prices magically work their way into future prices that's important; instead, past prices are significant because they are the best way we have to identify pockets of supply and demand in the market.

I'm the first to concede that technical analysis doesn't make predictions -- but bear with me. The problem with this claim is that the word "prediction" conjures up crystal-ball-style connotations; technicals don't do that, and I don't know a single professional trader or analyst who believes they do.

In practice, technical analysis is a way to find high probability setups in reaction to the market -- trading setups that factor in potential price barriers such as supply, demand and market mechanics and that give the trader cues about the market move with the highest likelihood.

Charts can't help a trader predict a stock's exact day-to-day price movement for the next five years -- but they can help generate consistently profitable trades with preset price targets and stop loss levels.

Myth 2: Academics Say Technicals Don't Work

In the past, academia hasn't been kind to technical analysis. According to prevailing financial and economic models such as Efficient Market Hypothesis and Random Walk Theory, technicals can't work.

But what most critics leave out is the fact that under those models, fundamental analysis tools can't work either.

While those traditional academic models have been powerful arguments against technicals in the past (as a financial economics student in college, I remember hearing the same), new research suggests that EMH and RWT are seriously flawed. Academic research as early as 1996 noted the fact that real-world market behavior (namely the existence of trends and occurrences of market crashes) makes Random Walk Theory statistically impossible. Similar results have been found to be the case with Efficient Market Hypothesis, which essentially claims that all available information is immediately priced into shares.

In reality, as events like 2008's market meltdown show us anecdotally, it's really how investors feel about that information that's reflected in share prices.

In the past, one of the biggest issues with academic studies of technical analysis has been the fact that the academics conducting the studies weren't particularly good at developing realistic technical trading systems to their studies. Now, as technical trading becomes more widely understood, academic studies are showing statistically significant outperformance from technical strategies.

Myth 3: The Biggest Investors Don't Use Technical Analysis

The idea that technical analysis isn't used at major funds and institutional settings is a common one, but it's another that's factually untrue. While fundamentally driven funds do certainly dominate the institutional landscape, nearly ever major institutional investment firm has a technical research group -- and all institutions employ trading floors filled with technical traders.

Even though technical funds and ETFs have only come onto the scene recently, some of the most successful investors and traders have risen to prominence using an exclusively technical strategy. Big names include the likes of Richard Dennis and Paul Tudor Jones -- even fundamental analysis icons such as Graham and Dodd made mention of technically driven factors in their explanation of the markets.

Ultimately, the merit of any investment strategy should be based on the successes of its best practitioners -- not the failure of those who don't fully understand it.

A Pragmatic Approach to Technical Trading

While technical analysis has become very popular in recent years, there are still a number of pervasive myths about technical trading that throw people off. Technical analysis doesn't use price as a way to magically peer into the future. It doesn't contradict the latest academic market models. And technicals have been used to successfully manage substantial institutional assets.

It's worth noting that technical and fundamental analysis aren't mutually exclusive investing strategies -- in fact, they're quite complementary.

To learn more, check out our other technical analysis primers on Stockpickr.

-- Written by Jonas Elmerraji in Baltimore.

Jonas Elmerraji is the editor and portfolio manager of the Rhino Stock Report, a free investment advisory that returned 15% in 2008. He is a contributor to numerous financial outlets, including Forbes and Investopedia, and has been featured in Investor's Business Daily, in Consumer's Digest and on MSNBC.com.

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