Skip to main content

Explaining technical analysis to a casual investor is a lot like explaining fishing to a random guy who's hanging out on the dock just to feed the seagulls. They nod, seem to understand, but the truth is they can enjoy their time on the dock just has much without ever putting a line in the water.

Let me be clear. I have nothing against technical analysis. To dismiss it as useless is just as foolish as using it as the sole input in your investing process. The next "TA" that appears on the Forbes 500 will be the first, to my knowledge. But in today's market, where algorithmic trading and quant theory abound, it's just silly to suggest technicals have no input into price. They do, but that doesn't mean you should rely on them solely for your investing.

I use charts to determine exit (sell) or entry (buy) points. This is probably the best use for the average investor. It doesn't take a rocket scientist to figure out that no matter how good the fundamentals of a company may be, if it is trading at a 95 RSI (relative strength to the rest of market) and is 10% above its' 20-day moving average, you're going to get a better price.

But beyond that it can be tricky for most people. I'll try and explain.

You won't hear this on TV often or from some technicians, but a chart can often be made to "say" anything you want, based on your bias. Even a good a good looking chart can be made out to be "overbought" or due for a "Fibonacci retracement" Change the timeframe, indicators, type of chart, and voila, you can craft a masterpiece to support your fundamental views.

If you enter on technical setup alone, this is when the problems begin. What if it breaks your support, which was your entry? I imagine a conversation between two rational people might go something like this.

First amateur TA: "Well, see there's support right here just a few dollars lower and it's already getting oversold."

Second amateur TA: "Oversold? The RSI is still close to 50."

First guy: "Oh yeah, but look at the volume, capitulation for sure."

Second guy: "But it had larger volume twice last year, why doesn't that matter?

First guy, getting annoyed. "I'm focusing on this year, plus see this right here, this is an engulfing candle!"

TheStreet Recommends

You get the idea.

There are technical analysts that can display extreme discipline and act only and solely on what they interpret on any given chart. The tickers are meaningless, just letters labeling a data set. These people are few and far between and if you're reading this, you're not one of them.

I've seen people that swear by technical analysis one minute then argue something has an inherent value the next. Which is it there, Mr. Wizard? The technicals don't apply to this long because it has "inherent value" or can be "taken out." You can tell yourself whatever you want.

Don't get me started on some of these names they come up with. Sometimes I can't decided if they are technical setups or rugby formations. This is bear flag, here's a wedge, breakout!

Think of it this way, even if we were to accept that a chart can never be wrong, we must then accept that our interpretation of said chart is also correct and that we'll have the discipline to act when that same chart tells us something different. GOOD....LUCK.

A fundamentalist might say, "I don't know anyone that has a GoPro or wants one." A technician might say, "Who cares, look at this rising wedge and MACD cross!" Both will mostly likely be right on different time frames.

Of course, admitting to yourself that you may not be the most skilled technical analyst is only solving one part of the equation. Don't be quick to accept every person that talks about technicals as a master technician.

I don't know about you, but I've seen pretty skilled doctors miss a thing or two on an x-ray -- and they just don't let anyone pass the medical board. It seems possible that even the most skilled TA may miss something here and there. By they way, don't make a point of pointing mistakes out to TA's, they REALLY don't like it. It seems to me that if your view of a stock based on the chart is repeatedly wrong, your process may be flawed, or perhaps the stock has decoupled from classic chart indicators. Maybe you should stop trading on the chart or offering recommendations on it. Just a thought.

If a person is wrong 40% of the time in investing in individual stocks, they're one great investor. It seems not only likely but probable that a chart may not be right any more often, doesn't it?

Technical analysis is not hocus pocus but it can lull one into a false sense of confidence. Know your limitations. Not being an expert technical analyst is probably one.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.