Is there a pattern to topping the charts?

Technical analysis can be a useful tool, but it should be treated with caution, says Iain Morse
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The Independent Online

Never mind rumour, never mind gossip. Get noise, opinion and prejudice out of your investment decisions. All you need to know is in the price of a share or the level of an index. This is the creed of the technical analyst and it deserves a fair hearing. But it often fails to receive it because charting, as it is also known, is regarded as the black art of investment analysis.

Never mind rumour, never mind gossip. Get noise, opinion and prejudice out of your investment decisions. All you need to know is in the price of a share or the level of an index. This is the creed of the technical analyst and it deserves a fair hearing. But it often fails to receive it because charting, as it is also known, is regarded as the black art of investment analysis.

Gerry Celaya, head of Red Tower Research, says: "Unless you really do know something nobody else does, you should assume the market factors all the available price-sensitive data into the price of a share."

That is not all. Prices and markets are never static. They have to be going somewhere, whether up, down or sideways. "So you use past price data to develop a probabilistic forecast of price movements," adds Adam Sorab, director of absolute return strategies at Deutsche Asset Management in London. "And markets do demonstrate some repetitive patterns of behaviour."

A vital part of price data lies in volumes traded. This is why you will often see price and volume changes shown on the same graph. "And volumes determine prices in a liquid, efficient market," says Mr Celaya. This is not an immutable market law but a valid generalisation. "Which is about as good as it gets in making investments," argues David Franklin, a fund manager at the private client City stockbroker Christows.

With this qualification in mind, trading volumes should increase in the direction of market trend. An end to increasing volumes should indicate the end of a market trend and vice versa. In conjunction, price and volume are taken by technical analysts to give reliable predictors of future market movements.

But technical analysts cannot always agree on how such market data should be interpreted. Some favour simple tools such as line or bar charts, point and figure charts or "candlesticks", first used in 17th-century Japan as a means of predicting the price of rice. More sophisticated "pattern analysis" looks for one of three types of pattern in a market: consolidation, continuation or reversal. Then there are Fibonacci numbers, the Elliott Wave, and Gann analysis.

"It's a matter of choosing a tool that works for you in practice," says Mr Sorab, "and the way you measure this is by whether you make money."

Very few enthusiasts for technical analysis argue that it alone should be used for all investment decisions. Most concede that it can best be combined with fundamental research which examines economic cycles and the underlying strength or weakness of economies and companies.

The cautious view is that technical analysis is a useful investment tool once a trend is established but not for predicting when the market is going to change its overall direction. But what investors can do is to use a system of buy/sell signals and stop losses that make it hard for them to lose money in a moving market. "The markets humble everyone," says Mr Celaya. "You can't outsmart them, but you can impose a discipline on your own trading."

This sounds very logical and hard to argue with; but technical analysis has its critics. "I believe in fundamentals," says David Berry, a fund manager at Martin Currie Investment Management. "The problem with technical analysis is that it can be used to prove anything. Or put another way, how do you disprove it?"

Home computers, software trading packages and real time streaming price data through a modem have made the use of technical analysis and trading tools readily available to private investors on such websites as www.digitallook.com and www.hemscott.co.uk. But treat with caution.

* Technical analysis can be daunting and confusing. The Society of Technical Analysts run courses for novices, and they can provide a helpful reading list ( www.sta-uk.org). Anyone wanting to hit the books is recommended to start with the bible of charting, John J Murphy's Technical Analysis of the Financial Markets: A Comprehensive Guide to Trading Methods and Applications.

'It's vital to be disciplined'

Max Burns, a self-employed private investor warns: "Discipline is vital if you use technical analysis. You need to be clear in advance that you understand what you are doing and set clear risk parameters on your trading."

Mr Burns and his partner, Sandy Grogan, have designed their own trading system. Does this make money? "Yes," says Mr Burns, "but our stop-loss is a vital part of the process."

Mr Burns claims a 40/60 success ratio, but by ruthless use of their stop-loss policy he and Mr Grogan claim to stay in profit. "There is no limit to how much we can gain, only to how much we lose," says Mr Burns, "and that is the secret of successfully using technical analysis."

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