February 10th, 2009
If you rely on charts to help make trading decisions by identifying trends, acceptable buy points or required selling levels then you must be flexible enough to accept fallibility. What makes it difficult is that it’s not the charts’ fallibility, it’s your own. Even though charts record a history of trades as fact, they are a blank slate as far as what those trades might portend for the future. That’s the realm of the “stock chartist”.But interpretation is subjective – subjectivity at a point in time and over time.
Two people can look at the same “blank slate” and see it two different interpretations. And those same two people can look at their interpretations and, after some time has passed, make two different interpretations. Does it detract from the process? Does it make charting invalid? Or does it just mean that one needs to be flexible enough to alter evaluations as new information becomes available just as one would had they been working with more traditional, fundamental data (latest quarter’s earnings report or yesterday’s new Treasury financial system bail out plan).
The answer is all in the eye of the beholder. Look at X (US Steel) to see what you would do. First, here’s a look at the “blank slate”:
Interesting, but without context, signposts or guidelines the chart is almost meaningless. Is the the stock continuing to decline at a faster or slower rate? To show that, we’ll add moving averages:
That’s a little more interesting. The moving averages confirm that the rate of the stock’s decline is abaiting. the 90-day moving average has started to flatten out and, if the price merely stays around the current level, it will cross above the slower 90-day moving average merely by the latter’s continued decline. But it, too, will start flattening if the weight of further declines in the price doesn’t drag it lower.
Next, we want to know the extrapolate from past experience what might be the stocks near-term “reflective boundary” (trendline), the price levels where the stock has failed to change direction. This is important because if the boundary (trend) is penetrated, there’s a strong possibility that there’s sufficient momentum to reverse direction in the short-run. The “herd” may have begun stampeding after the stock so purchasing the stock entails less risk.
But this is where the analysis truly becomes subjective, less risky only in the eyes of the beholder. I described the differences between trendlines and moving averages on August 7, 2008 when I described a trendline as “A trendline, on the other hand is the extrapolation of a vector of where hypothetical past and future potential pivot points.” But drawing trendlines is an subjective, more and art than a science. And this is where humility comes in.
There are several chart patterns that could be drawn on the X chart above (arranged chronologically). One chart pattern is a symmetrical triangle indicating a struggle between equally powerful buyers and sellers:
As a few trading days pass, one could insert different trendlines resulting in a rising wedge, usually considered a consolidation (indicating a continuation of the decline as the price breaks through the bottom trendline) rather bottom reversal pattern:
Finally (more correctly, until more trading days pass by), a ascending triangle indicating a high probability of the stock breaking above the upper boundary trendline and a solid reversal:
All this means is that there isn’t any “correct answer”, only the best answer consistent with the bias of the analyst. If you’re bearish on the market, you’ll believe you see a rising wedge; if you’re bullish, you’ll see a triangle. I’ll just wait to see if these patterns are confirmed by the moving averages, by the health of the overall market and by either the stock breaking above/below either the upper or lower trendline (i.e., reflective boundary).