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Why Technical Analysis Works

A look as to how psychology ties into technical analysis, and why it works.

Lucifer Morningstar

Many fundamentalists and normal people must think technical analysis is silly. How can drawing lines like a four year old dictate price movements? Truth is they're right. It is silly. But for the most part it works. Here's why:

People believe it works

If everyone believes that their fibonacci ratios and reversal patterns work in the stock market, then many will set their buy/sells at key levels within these movements. That's important because if you can read what they're seeing, you can anticipate what people might do at what level. There are those who don't care for fibonacci levels, but they will still place their stops/buys at key levels. The idea that others will buy and sell based off the principal that others will buy and sell at certain levels, well, that's like some type of self-fulfilling prophecy. I mean this just paints the stock market as a giant chess game. Psychological warfare. I firmly believe it is. It explains why those who are clever win in the end. You don't need to always trade off of fundamentals because you're not trading companies, you're trading human emotion.

It's Psychology

Humans are unsurprisingly predictable. Technical analysis works because humans like to follow patterns. Us technical analysts try to capture opportunity by using market sentiment and rationale rather than the fundamentals of a company (I try to use both when I can so don't roast me). The direction of price action is often dictated by the fear and greed of others, not always by the valuation of a company. I think this was made evidently clear this year with the GameStop saga and wild price hikes in stocks. FOMO (Fear of missing out) is a very real condition for the mentally weak. People see their friends getting rich off AMC and Bitcoin and want to join the party. Speculative shots are called via social media nowadays by Lord Dave Portnoy and Zack Morris, and who the hell wants to miss out on that? Only when there's no one left to buy does the momentum finally stall. As for support and resistance levels, they work partly because of regret. People remember the price they paid, or the price they wish they had paid, and that memory then shapes their behavior. If people could have bought a stock at $6 and it's now trading at $10, they'll be more inclined to add if it pulls back to $6. What about oscillators? Well, that is just too complicated. People don't like things that move too fast (unless you're Vin Diesel). These oscillators and indicators are just tools to help your system, they aren't guaranteed gains.


It takes time for the market to digest news

Algorithms have certainly made it harder for traders to gain an upper hand in reacting to stock news. Stock prices move fast the moment a headline hits, so by the time you see it, you may already be too late. That said, algorithms are pretty good at picking the direction a news event should move a stock, but not necessarily the impact. The initial fast news response is often followed by a slow news response as the information spreads through the human population and its implications are assessed and priced by human traders. Being able to digest information quickly puts you ahead of the herd.

It wouldn't be fair to not mention some reasons why technical analysis may not work. A few key points include:

  • Traders try to create signals. It's so easy to be led on by own confirmation bias. Of course you want to have conviction in your plays, but combating the trend can lead to mass destruction. Trying to justify getting shlonged by shorts because of some sort of indication telling you to stay can cause your portfolio to get flushed. Traders also have a hive mind, so for instance many will see the same thing. If everyone is buying at the same signal what do you think is going to happen? It may not ever reach the desired price level.
  • Whales will eff you. If the big boys know that you and your retail buddies have stop-losses set at a price, you better believe they will bring it down to flush you out and buy shares at a cheaper price. It's a stupid game and people don't realize that. Technical analysis helps us identify points where others may be buying and selling, and that's an advantage.

Do I use technical analysis? Damn straight. But I also think it's at its best when used with a good understanding of its limitations. Like, I find patterns to work more on the bullish side than bearish, due to the nature of the markets upward bias. Legend says that "STONKS ONLY GO UP". I also like to combine fundamentals to form a thesis on WHY the stock would go up. Not just because of the nature of its chart. Understanding why you're in a stock and being able to see past the BS games that are played is an upper hand. If you know what you got then you shouldn't be worried about the games.


*For more information, here's a link on the myths of technical analysis.

**Not a financial advisor.