Another check into my stock market experiment. This time I look into how people operate to analyze a stock. There are two major schools (maybe three): Fundamental analysts or value oriented traders, Technical analysts or chart-watchers, and there’s Random Walkers which I still don’t get.
First off are the fundamental analysts who determine the value of a stock by looking at earnings targets, inventories, and all sorts of underpinnings of how a company operates. The hypothesis is that a stock has an inherent value based on all those factors and will move towards that value from the current stock price. Technical analysts look at charts of price to determine price motion and momentum under the hypothesis that there are patterns of movement based on cyclical flow of capital and trader psychology. Random Walkers‘ hypothesis is that markets are efficient and the price is not influenced by company valuation nor other traders.
I’ll cut to the chase here and point out I’m probably a chartist, but it’s interesting to look at the different styles. Random walk theory seems more or less un-american. It essentially says the stock market is a coinflip, and that it’s not worth trying to time it or game it because it’s a self correcting mechanism. I think, then, that there’s money to be made when it’s correcting and moving. I’ve found that fundamental analysis maybe works in a long term investment mode, but a year or more is a long timeline to be potentially wrong. Technical analysis favors shorter timelines and I think most of its tenets ring true for me.
The main one is that there are a lot of players in the stock market and most (if not all) positions are bought and sold by people with emotion that causes patterns of buying and selling. For example, emotions cause people to hold onto stocks because either an exuberance of making money or the glimmer of hope that a stock will make a comeback. This generates levels of supply and demand in stock prices. The crowd will collectively determine the price of the stock as it flows between these levels of support and resistance. It’s uncanny, but on almost all stocks if you just draw lines connecting the tops and bottoms of price movement predictive patterns emerge almost immediately. Now, not all of these patterns play out, but that’s why there are stop orders and limit orders to minimize risk.
Knowing that I agree with technical analysis still does not get me to the point of picking stocks. There are so many ways to analyze a stock’s price I can see why fundamental analysts view chartists derisively. In fact, just showing a stock’s price on a chart is not as easy as it sounds. Prices are generally shown on a chart as points on a line referring to the closing price of a stock on those days. What’s missing from this? The price a stock opens, for one. Also how about the high and low on that day. There is a bar chart that uses “OHLC” bars (as in Open-High-Low-Close) but I use what are called “Candlestick” charts because they show all four of these points, and they’re more visually pleasing. I.e. me-like-pretty-colors. I think the highs and lows will better indicate emotional levels of the price supply and demand that just the open or close. There is a whole school of candlestick analysis using fancy terms like “Doji” and “engulfing” based on Japanese trading analysts from the 18th century (that’s right, capitalism is not new). The analysis of certain patterns of candlesticks is certainly very interesting, but I haven’t looked into it heavily.
I pretty much just draw lines. I’m still on my way towards developing a strategy that works for me, so for now I’ve been just taking the major lists of stocks and drawing lines on their charts. I use FreeStockCharts.com which I admit is ultra-lame for requiring MS Silverlight, but it really is the best free stock charting out there. I’ll choose a list of stocks like the 30 stocks that make up the Dow Jones Industrial Average or the 100 stocks that make up the NASDAQ-100 index or if I’m feeling especially bored I’ll try the 500 stocks in the aptly named Standard and Poor’s 500 (AKA, the S&P 500). A real glutton for punishment might do the entire Nasdaq Composite index (3000 stocks) or maybe the Wilshire 5000! I’ll go through the list and draw some lines connecting highs to highs and lows to lows, and I’ll extend those lines into the future. I created an account on the site so it saves the lines and I’ve done it enough times that sometimes I’ll hit a stock I’ve visited a few days or even weeks ago and I’ll see the stock’s current price still within those lines! What a feeling!
Obviously, I don’t have time to draw lines on every stock chart ever. Also, for all the times a price stayed within the lines I expected there were many that were out of the lines. Some were below the “support” lines I drew but some were above the “resistance” lines. Thus, there must be more to this than just the line-drawing analysis. I need a method to feed the analysis more programatically, and I need to refine the analysis.