Why do we use charts?

The Dude spent almost 15 years trading commodities futures in the pits before computers took over the show, after which he went upstairs to write chart-based trading algorithms. When he started trading, he drew his charts by hand.

If you want to experience charts like The Dude did when he drew them himself in the pit, import the following theme to Cryptowatch: “The Dude Paper Charts,#FBF9F4,#3A354B,#F5FC2B,#AD0002,#3759A6,#212121,#CB0B12”

Real view of the old trading pits
A particularly hot sell in the trading pit – from Trading Places.

As a long time charts user, I’ve been scorned, laughed at, pointed to, told I practice voodoo, etc. That slowly led to people asking my opinion, followed by many of the same becoming investors in funds I opened focused on automated trading models that were based on, you got it, chart setups. 

More recently I’ve worked to build charting platforms for others, as well as taught and mentored technical analysis, aka using and interpreting charts. One of the key words in the last sentence is “interpreting.” Like most types of analysis, good technical analysts won’t say what will happen. More often they will say what could or should or often happens. 

Charts aren’t always right. That’s not the idea. 

So what is the idea?

“Why charts?” for me was a pretty simple question to answer soon after I was introduced. My answer was because they work. They work to provide me with information. I tell people I’m an information junkie. I seek out information. Oftentimes it’s just useless information that I find interesting at the time. Information is the key to any decision we make. More information or less, good information or bad, we still use that information. 

Once you collect as much information as you can, or as much as you think you need, then it’s time to make a decision. This process of gathering and interpreting information is where it begins to get interesting. First, in trying to answer the same question or find the same solution, people seek out different types of information that they believe will help them make the most informed decision possible. Second, when given the same information, it is interpreted and acted on in different ways by different people.

Gathering and Interpreting Information

Let’s look at both of those situations: interpreting information differently and seeking out different types of information. 

Gathering information can take many forms beyond just waiting for a story to hit a newswire. I’ve known analysts that will call CEO’s directly during takeover negotiations in order to gauge the probability of a deal being repriced or being consummated at all. Trying to get better information, hopefully sooner than others – that was their competitive edge. 

What about the second part; analyzing the information? Traditional financial analysts, all those people with business degrees from the top schools: they look at the same balance sheet, read the same financial statements of all types, hear the same company estimates. Then some say Buy, while others say Hold, or even Sell. So how does this happen? It’s a matter of interpretation. And sometimes even trust: is the company trying to mislead a bit to influence a stock price? This is by itself not a rare occurrence. After all, money is at stake – executive salaries and bonuses, to say the least.

With all these smart, highly trained people competing against me, I wondered where my edge was going to come from as a trader. I found it in charts. I accepted very early on as a gold futures trader that there was going to be someone who had more information than I did. I also accepted that if we all got a piece of information, someone else had it before me. So I started learning about charts – because if others had more information, had it sooner, and were better trained in interpreting that information, all I really wanted to know was what their conclusions were. 

Instead of trying to track them all down, get them to share this information and then try and weigh whose opinion should carry the most weight, I learned to find these opinions through their actions. Did they think something was undervalued or overvalued? It was simple. They either bought or sold. And with a chart, all in one place I could see not only which opinions were stronger and getting the most backing from market direction, I could also interpret the strength of those opinions through market momentum. All of a sudden, the only information I really needed to start forming my own opinions was: is the price going up or down, and how fast.

Sourcing my information this way is much like what a good bookie does. No wonder trading is often described as nothing more than being in a casino. I’m ok with that. In fact, we don’t even need the fancy casino trappings or free booze and show tickets. It’s really just a world of bookies and suckers like in so many neighborhoods throughout time. 

The best bookie plays on psychology and people’s emotions. So does a good trader. And this use of charts is really just a more physical representation of what that bookie is thinking about. Which way is the crowd leaning? As the crowd changes its perspective, the bookie will adjust the odds. They are reacting to other people’s decisions to best position themselves to make money. And if they had charts, they’d get to watch the entire scenario unfold in a time series.

I’ve often described technical analysis and the use of charts as a poor man’s statistics. After all, a good statistician is looking at people’s behavior, their reaction to information, and trying to figure out what has the best chance of happening next. Much like that bookie. This too is what charts do. They let you look at the results of previous situations in markets that show similar characteristics to what is happening now and derive some probabilities from there.

I dropped my intro to statistics course in college. I just didn’t see how it would apply in my own future. I didn’t realize that insurance company actuaries aren’t the only ones who would find value in it. Over the years, I gained more and more respect and admiration for those actuaries. I also realized that actuarial work is another acceptable and legal way of being a bookie. It may be people’s lives instead of a football game, but we’re still just dealing with odds, the odds of someone dying or being in an accident instead of the odds of 3 goals being scored. In the end, it’s still placing a bet.

Using Indicators 

At what point do we turn chart analysis into something more than just an up or down bet? Or to put it another way, how do we decide the when (or wen) part? This is the part where we need to first add some science before we add in more art. When people look at chart analysis, mathematical derivatives of price are often used to add a layer of filtering. While there are hundreds of these overlays, from Average Directional Index (ADX) to Z-Score with Moving Averages in between, they all fall into no more than a few categories; momentum, mean reversion, statistical, etc.

This use of derivative indicators is often mixed with pattern analysis and interpretation. This is where there is often more art than science. People talk about Head and Shoulders, Shooting Stars, Bull and Bear Reversals. These patterns are designed to be looked at as ways to decide when something will keep going, stop, or turn around. Some of these tools go back hundreds of years. The Golden Ratio (not to be confused with a Golden Cross) value of 1.618 is derived from the Fibonacci sequence, discovered by Leonardo Fibonacci who lived about 800 years ago. That number, also named Phi through time, and its inverse of 0.618, are part of one of the most widely displayed overlays used by technical analysts called Fibonacci Retracements.

Do Charts Work? 

The obvious question that remains is, does this stuff really work? How and why? Here’s where it turns into a debate. Many people look at the use of things like trendlines and common indicators as merely a matter of crowd behavior, a bit like lemmings. A large group of people look at the same trendline drawn from the same points below the current price will commonly interpret this as a place of support, like a floor under a declining market. These people all see the same number and reach the same conclusion: it’s a place to buy. In turn, we have a self-fulfilling prophecy – the market doesn’t go down further as buying increases.

We can also argue from a supposedly more scientific (or sci-fi) version that the math behind these levels and momentum measurements, etc. have resulted in the movements and gyrations we’re witnessing at any given time. I’m pretty much fine with either of these explanations. And like so many things, it’s probably just some balance between the two. This is, again, a case of analyzing the behavior of a group of people. In our first example of the trendline, we’re just looking at a smaller sample of people: those looking at charts. Whether we’re looking at technical analysts or every participant in a market, we’re still just looking at the decisions of others and deciding how to react ourselves. Just like that bookie.

Are charts more reliable than other analysis? This I can’t say. I can say that I’ve watched technical analysis go from being a very small part of the overall community to having established itself as a more acceptable voice in the room. I’ve debated with many different traders, portfolio managers, fundamental analysts and just plain cynics whether there really is anything in those charts. I tell them all I’m trying to do is increase the odds of me being right. I explain that when I look at a chart it quickly gives me a starting point. I have faith in history repeating itself, at least to some degree. That’s all I’m doing. Looking at the past and deciding if we’ve forgotten it enough to react the same way to whatever may be going on in the world around us. Easier than analyzing P&L, Balance Sheets, Supply Chains, and whether the CEO is a good person or not.

To me, there really isn’t much of a debate. For no matter the reason or answers to how and why, if something helps you make better, more informed decisions and in turn more money, then that thing works. So use it. 

Unfortunately it’s not quite that easy – it does take work, and reinforcement. There’s always doubt, but as history repeats itself, as you find which momentum measurement works for you, whether you trust Elliot Wave or Ichimoku patterns more, you’ll find what gives you the edge. In the end, my final argument for charts is simply this; a picture is worth a thousand words. I’ve written close to 2,000 trying to explain all this, when what I really should have done is simply posted a chart.

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