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Technical Analysis and Programmed Trading: Useful Tools or Market Hindrance?

The old adage that "history repeats itself" is certainly true as it applies to the stock market. There are stock market traders called "technical analysts" who often rely exclusively on reading price patterns over a period of time in order to make their investment decisions. This method of trading, known as technical analysis, allows for traders to look at price patterns through different types of charts. Their approach differs from fundamental analysis, which focuses purely on the economics surrounding a stock, such as the sales, earnings and future outlook for a company. The most common charts used in technical analysis are line, point, figure, candlestick, and bar charts. Online educational resources for investments, such as investopedia.com, provide detailed information about these various types of charts that can help you to get a better understanding of their specific configurations. For our purposes, we will focus on the concept of technical analysis as an added tool in our effort to understand the price movements in the market, rather than on how specifically to construct such charts.

Some critics of technical analysis believe the entire strategy relies on a theory of self fulfilling prophecy. That is, so many traders follow these charts and chart patterns that the reason such an approach works is simply because so many people use it; implying that their reactions to chart patterns cause the very price movements from which they may profit. There may be some truth to this criticism; however, it very quickly becomes an argument of which came first, the chicken or the egg? Various moving market factors will cause price changes, and those changes can be recorded in chart form. Over time, a number of the newly recorded changes form a pattern which in turn causes technical analysts to either buy or sell the stock. The more traders who follow the pattern, the more orders there are to buy or sell. At some point, all of the orders cause new chart patterns, which in turn cause additional technical analysts to react, and so on and so on. While this may seem confusing, it is actually a very logical cause and effect relationship. The real question becomes, does technical analysis work? The answer is yes, but it is contingent upon how it is used.

As we are firmly entrenched in the technological era, it is important to understand that much of the technical analysis today is done by computer. Prices are collected real time, computer software is very sophisticated, and charts showing price patterns are very detailed and readily available. Many high tech traders have actually connected their computers to order entry systems, and the newly emerging price patterns then instruct the computer where to place the buy and sell orders. This process has become known as "programmed trading." While programmed trading has proven very successful for many large traders, it has also proven to be problematic to the market on occasion. In recent years, we have had several major market price swings in a matter of minutes as a result of programmed trading; a problem that refers back to the "self fulfilling prophecy” argument referenced earlier. When hundreds of large traders are directly connected to the market using essentially the same or similar programs, a major move can occur when everyone gets the same signal at the same time. , Subsequently, these occurrences have often caused the average investor to take heavy losses—or, at the very least, to suffer some sleepless nights.

There is, however, a very useful application of technical analysis that can improve our stock trading results. For many years I have combined fundamental analysis with technical analysis. This simply means that once I have researched a company and have made the decision to buy stock, I use technical analysis to help me find the most advantageous entry point into that stock. For example, I would review all of the fundamental information on Widget Company X: sales, earnings per share, outlook for the future sales of widgets, and competitive threats to the widget industry. Once I have made the decision to "buy," I have a choice to simply place a buy order for the quantity of shares I desire, or to take a look at the charts and review information such as the historical perspective of where prices have recently been compared to their 2 year or 3 year range, for example. The “technical analysis” (review of the charts), may indicate that the price is due for a setback, or a rally—or that it will simply remain at current levels for the near term. The review of such analysis will therefore help me to decide at what price level I will place my buy order.

I have included two charts below showing the performance of the Dow Jones Industrial Average over two time periods: from 1980 - 2000, and 2001-2012. It is interesting to see how most of the many peaks are followed by troughs; a pattern that could help potential investors to better time purchases and sales.

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©Patrick J. Catania 2012
The views and opinions expressed herein are solely those of the author and do not necessarily reflect those of Baxter Credit Union, its Board of Directors, or its employees. The author is responsible for the content. Readers should consult with, and seek professional advice from their own attorneys, accountants, and financial advisors with respect to their individual financial needs and circumstances.

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To conclude our discussion, I see the value of technical analysis as being supplemental to fundamental analysis, serving to improve overall performance by helping to enter and exit the market at the most advantageous price levels. The experienced CFS Financial Advisors* at BCU are well versed in the possibilities of using technical analysis in support of a long term investment strategy and have a wealth of knowledge and resources to help you navigate your best options. To schedule a free, no-obligation financial consultation contact 800-388-7000 ext. 8700.

©Patrick J. Catania 2013

The views and opinions expressed herein are solely those of the author and do not necessarily reflect those of Baxter Credit Union, its Board of Directors, or its employees. The author is responsible for the content. Readers should consult with, and seek professional advice from their own attorneys, accountants, and financial advisors with respect to their individual financial needs and circumstances.

*Non-deposit investment products and services offered through CUSO Financial Services, L.P. (“CFS”, a registered broker-dealer (Member FINRA/SIPC) SEC and Registered Investment Advisor. Products offered through CFS: are not NCUA/NCUSIF or otherwise federally insured, are not guarantees or obligations of the Credit Union, and may involve investment risk including possible loss of principal. Investment Representatives are registered through CFS. BCU has contracted with CFS to make non-deposit investment products and services available to Credit Union members. BCU Investment Advisors is a trade name for the investment services available at BCU.