' Charting Markets– What sort of living? ’

Based on an speech by Richard Cook- June 2000

Charting

Charting (sometimes-called Technical analysis) is an increasingly popular way of trying to predict market movement.

In the hands of an experienced trader, charting is a powerful technique, and most of the best speculators use charts to select and plan their trades.

Even for the novice investor, charts help provide a useful perspective on the markets.

What sort of profit is it realistic to expect, from charting or any other method?

The answer of course depends on the chartist’s skill, the nature of the markets, and many other factors including a dose of good luck.

Only the shysters and con artists can promise to make you rich, quick.

Many recently promoted products based on technical indictors, offer fabulous returns, measured in hundreds of percent.

But the facts of life are that a return in excess of even 20% per year, is extra ordinary and can only be achieved at a high risk to your capital. Such high returns do not persist, and initial gains are usually soon reversed.

Even Warren Buffet, arguably the greatest corporate investor of all time has produced returns of only about 28% per year compound, over the past 20yrs or so.

Many consider Microsoft to be the most spectacular growth company of all time, yet Microsoft has generated only an annualised return of 50% (Up until 2000)

If these returns sound paltry, then you do not understand the realty of investing, or the underlying principles.

So .. what sort of people are likely to be offering investment products returns in excess of 25% .. I leave it for you to judge !!.

Just remember that the greater the REWARD the greater the RISK, and if the rewards are so good why on earth are you being dealt in ??.

Before you consider buying a magic carpet ride to Xanadu, consider the following facts.

The All Ordinaries accumulation index has returned approx.17 % compound since 1975. ( Aug 1985 – Aug 2010 return = 10.8%)

But in any single year, only one third of managers beat the All Ordinaries Index

Furthermore over longer periods of ten years or more, only a tiny minority of one to two percent of fund managers beat the index.

What all this means, is that almost none, of the best-paid and brightest fund managers are able to add any value to the average return available from the market. In short it ‘a’int’ easy. Even the best of the professionals rarely beat the market average index, over long periods.

The only way to beat the index is to pick better stocks than the average, or to get out before the market turns down, and then get back in before it goes up again. A fund manager would only have to this once a year to beat the market, but most of them can’t do it in any year, and almost none, can do it over the long haul.

So what does this prove?

It shows just how hard it is to be a good trader.

Although many traders experience a purple patch, with extra good returns for a year or two, they almost always falter in the long run, whether they rely on charts or any other method.

Why is it so hard to beat the market ?

In order to beat the market you have to be able to match the magic of compounding returns, not only do you have to keep winning to match a rising stock market, you also have to keep increasing the size of the bet. (When you reinvest your winnings and/or dividends)

This for many of us, is a psychological difficulty. I for one, get comfortable with a certain size bet, and don’t like to raise it, even when my wealth is increasing.

There are other major hurdles to out performing the major stock Indexes.

These include; you must pay tax on your winnings, pay brokerage, you have to work hard to find great trades, and sweat blood while you wait for them to meet targets. Even worse you have to get used to selling under performing stocks at a loss. For most traders, taking any loss is difficult, and generates a fair amount of anxiety.

What can be done?

The alternative is to just buy into an Index fund.

The index investor simply buys and forgets about it, and what’s more, he is likely to do better than almost all traders, especially in the long run.

This is mostly due to stock dividends, and the power of compounding returns.

This is also known as the buy and hold strategy.

All other investing strategies should be measured against this strategy.

If the investment strategy you choose to use, does not beat the index over the long run, then it is worthless and should be discarded.

Unfortunately, by the time you discover this, it will be too late. After all as Milton Keynes noted, "In the long run we are all dead."

Still interested in Charting? then read on.

The case for charting.

Index funds provide a safe but boring way of participating modestly in a bull market. But in a bear market your Index fund will lose money at exactly the same rate as the falling Index. Whereas in a bear market the successful chartist still has the opportunity to recognise the bearish patterns, and then stand aside, or even to short sell the market.

This has the double bonus of accumulating money, which can later be spent on even cheaper assets or stocks.

Charting is an easy way to analyse the markets.

The chartist believes that the past behaviour of a markets price, can provide clues as to its future direction.

By simply glancing at a price chart of any stock or market, the experienced chartist can quickly form an opinion. It is no wonder that this technique has become increasingly popular, especially considering that other forecasting techniques require many hours spent studying fundamental statistics in order to develop an opinion.

The chartist simply looks for telltale patterns in the price chart, and then based on the past observation of the outcomes of these patterns, he attempts to project the likely direction and extent of future price movement.

Anyone who takes the time to view a number of stock, currency or futures charts will notice that certain discernable price patterns appear in most price charts, whether they be Microsoft or Pork Bellies.

These recurring patterns have been studied and labelled by generations of chart watchers.

Such patterns are universally known by names such as "head & shoulders top", "wedges", "triangles", "bull consolidations" etc.

A classic bull consolidation pattern is illustrated below.

The chartist watches for the development of such patterns.

Then from the shape of the pattern, the chartist predicts the future direction of price, and buys or sells the stock accordingly.

Chartist’s using computer charting programs also have at their disposal a very large number of market indicators. The computer calculates these indicators from the price and volume data that makes up each chart. For example, momentum indicators moving averages etc. The chart technician uses these indicators, as another means of predicting when a market is likely to change direction.

Does It Pay?

Charting is at best an inexact science, the reliability of chart patterns is very much dependent on the skill of the observer. Although past patterns may seem very obvious, skill in identifying current patterns as they develop is very much more difficult.

Charting is after all, an attempt to predict the future.

As yet there is no scientific or statistical proof, that any of the many charting techniques are consistently profitable.

However under certain favourable market conditions the skilled chartist can make significant profits.

This is probably similar to card games.

When the cards are running right, the skilled gambler can win big. As in cards, the skilled chartist makes his trades, not with the expectation of winning every time, but with the hope, that given that market conditions turn out favourably, then enough of his trades will be profitable to cover the inevitable losses.

However all chartist pay a high tuition fee, before they learn the skills and market savvy, that allow them to profit from this form of speculation.

While it is difficult to quantify and test the reliability of chart patterns, many attempts have been made to prove the predictive power of indicators, such as moving averages, momentum indicators etc.

The results suggest that while all these indicators work some times, none have been proven money makers, in all market conditions.

On balance they are probably as likely to make you poor, as to make you rich.

This accords with my own observations.

Most of the very successful chartist’s I have known, have concentrated on the observation of price patterns, rather than technical indicators.

This is unfortunate, for it is of course much easier to learn to use a technical indicator, than to develop the highly subjective skills of chart pattern recognition.

How to use charts.

Developing acute skills in pattern recognition, can probably only be acquired by years of observing and studying market charts.

Nevertheless charts can still be very useful even to the beginner.

At the very least, a chart provides some sort of perspective on the stage of the market. For example, is the current price very high relative to its recent history. This simple observation may help to prevent you jumping into a market that has already run up too far, and which is now very likely to become subject to the forces of gravity.

By using charts, even the casual observer might have seen the danger signs that many internet stocks exhibited, before their recent collapse. For, on the balance of probabilities, a stock that has multiplied in price many times in only a few months is a dangerous investment. And the chart makes this dangerous rate of growth very apparent.

Even a passing familiarity with charts can provide a useful insight into whether or not, a touted investment is already too over bought.

Long Term Charts

To get a feel for any stock, a good chartist attempts to study as much price history as possible.

The most convenient way of presenting long-term history is in the form of monthly charts, where each price point represents one month. This allows 20 or more years to be shown on a single screen. (or page)

From these long-term monthly charts the viewer can readily see the kind of behaviour typical to the market. For example, has the market risen or fallen in a constant trend, or does it exhibit a cyclical nature.

If a market has been in a constant up trend for many years, then it is on balance likely, that prices will generally continue up.

Whereas if the long term chart shows the market rising and falling with a regular rhythm, then it is probably prudent to believe that some sort of business cycle affects the price of this market, and to make trading plans accordingly.

The long-term chart gives the chartist an immediate insight into the market.

The chartist does not need to study balance sheets, demand and supply figures, or cash flows in order to develop his views, because all this information is already condensed into a single price chart.

From the long-term monthly or weekly charts, the chartist develops a feel for the likely overall direction of price in the coming months.

The chartist then views a daily chart, of the market in question. Daily charts usually illustrate about one year of price history.

Using the daily chart, the chartist will look for developing price patterns.

The chartist looks to see if the chart is tracing out a recognisable pattern that would both confirm his overall view, and allow him to develop an actual trading plan

The Trading Plan

The chartist draws his trading plan directly onto the chart.

The trades entry point, stop loss, and targets are all set with reference to the chart pattern. See the illustration below.

A good trading plan always requires that first of all the total risk is quantified, and then a risk/reward strategy is put in place. In both these regards the chart is very useful.

Based on the chart pattern, the entry point, the stop loss point and the price targets can be identified. The stop loss is the price at which the trade will be abandoned if the price moves in the wrong direction. This stop loss is the most crucial element in any trading plan.

Once an entry price and a stop loss are determined, the chart can be used to measure out the price targets. Furthermore the experienced chartist can judge from the placement of the stops and targets, whether or not the plan is a realistic one, in the context of the long-term chart and the chart pattern.

Charting as a necessary, but not sufficient technique

Chartists have yet to demonstrate they can predict the future with any sort of scientific reliability, but then neither can any other competing technique.

At the very least, charts provide a useful perspective on the stage of the market, and at best they provide a template to predict price movement. Using charts together with a good trading plan can reap significant returns under the right market conditions.

But unless the chartist can make profits that exceed the returns on indexes such as the All Ordinaries accumulation index, (dividends reinvested) then he or she should consider that they are wasting their time.

Charting in a bull market

In a powerful bull market, anything that encourages the investor to buy is likely to succeed. Charts can provide this confidence.

As the chartist watches the earliest bull patterns break out and run skyward, his confidence and willingness to invest is increased. As more and more stocks build bullish platforms the chartist develops both the enthusiasm and confidence necessary, in order to become an active player. This confident response, is what the making of big money always requires.

In this situation the charts also provide a means of selecting the best patterns among the many thousands of stocks available. The chartist can see at a glance whether or not a chart pattern meets his criteria, therefore it is possible using a computer for a chartist to view many hundreds (or thousands) of stocks, in order to select the best opportunities.

The chart pattern then provides the entry point, the stop loss point, and the target.

Given that the chartist has the money and stomach to play hard, charts provide the structure around which the trader builds his confidence, strategy, and his wealth.

In this scenario, significant profits can be generated. The more powerful the bull market the greater the profits are likely to be.

Charting in a bear market

In bear markets, the chartist need only stand aside to out perform the overall market.

If the charts alert him to remain on the sidelines, then they already proved valuable. If in addition, the charts encourage a short position, then the chartist’s wealth will quickly escalate, especially in relative terms.

Charting without a trend.

The most difficult time for the chartist, is when the markets are generally moving side ways. That is, moving in a random walk, where patterns develop, but fail to break out into clearly defined up or down trends. Unfortunately, this situation holds sway in most markets much of the time

In this scenario the chartist must be careful to preserve his capital.

The difficulty is that most chart patterns will not fulfil their promise, and the chartist will lose money on these trades. Even worse, as the losses pile up, confidence will be lost in charting methods, and the chartist may find he lacks the enthusiasm to participate in the next big bull market.

At this point our discouraged chartist may feel inclined to join us, the legion of other chartists, engaged in teaching others how to do it!

As George Bernard Shaw once declared "He who can, does. He who cannot, teaches.

By Richard Cook

Chart breaking out of bull consolidation.

Entry point at $22, stop loss set at $20, target set at $28.

(Risk reward ratio is 1:3 i.e Risk of $2 to make $6)

Two bull patterns , purchased on June 27^th 2000

For current daily examples see http://www.proview.com.au/hotchart.htm