Avoiding the Squashed Frog: An Analysis of Chart Analysis
By Martin Tillier
Let me tell you a secret. Most people who are paid, rather than who pay, to trade, don’t spend all day studying charts. They’re too busy trading. Most long-term institutional investors don’t spend all day studying charts. They’re too busy researching fundamentals. It seems to me, however, that most individual investors and traders are obsessed with these things. They eat up all of the analyses that show “jug and handle,” “batman ears” and “squashed frog” patterns. (Okay, I made the last one up, but the other two have been written about.) I am not saying that, in my experience, market professionals don’t use charts. Of course, they do, but if a pattern is so obscure that it is not immediately visible or needs to be explained in detail, it is probably a coincidence, not a pattern.
For long-term investors, in particular, technical analysis is of limited use. If your typical holding period of an investment is one year or more, then looking at sales and earnings of a company is far more important than studying price action. Entry points matter, but their importance can easily be overstated. If, eight years ago, on September 21st 2004, you had seen the long-term potential of Google (GOOG), does it matter if you bought at the day’s low ($117.51) or the high ($120.42)? The difference over eight years is 15% of your original investment, but I would still take a 509% return had I bought at $120.42. Spotting the opportunities for the company is more important than spotting a pattern in the price.
For many investors, though, at least a portion of their accounts are dedicated to shorter term trading. Whether this is to juice returns or really just for fun, the need for an analysis of price action is the same. People I know who are paid to trade do use charts but they generally look for fairly simple patterns, the most important of which is a range. There are many things that investors should learn from traders, but defining a trading range and interpreting it are two of the most important.
Here are three very different uses of range analysis, using three different stocks, Micron Technology (MU), Terex Corp. (TEX) and General Electric (GE). In each case I have used a 6month chart for perspective, but drawn in ranges based on 3-month highs and lows, up to September 21st 2012.
First, let’s look at Micron (MU).
This is a classic range-bound stock. It has traded between $6 and $7 for three months, hitting tops and bottoms. The range is beginning to narrow as people trade just in front of previous levels, which is to be expected. Any move to around $6 would be a buy signal. Not only would this give upside potential, but it would also offer a logical stop loss level at around $5.70, only 5% away.
Terex (TEX), on the other hand, looks very different.
When a range narrows this quickly a break-out is almost certain to happen. Now is not the time to get involved. Anything could happen from here. During a steep rise like this, technical analysis is of little use. Fundamentals, whether macro or micro, have changed. By all means ride the momentum, but know that the real short-term chance has gone.
Not every break-out means that the opportunity has been missed, however.
In my experience, the pattern shown by GE stock leads to a different conclusion. A move out of a wide, stable range such as this usually leads to a new range being formed. If the top of the previous range becomes the bottom of the new one, as often happens, then buying now, with a stop at around $21.00, could be a good trade.
Be careful. In any analysis based on charts, what time period and criteria you use affects the way it looks and your interpretation. This is why I have used the same criteria for each example. There is a tendency to make the chart fit the theory, which ultimately tells you nothing. Consistency is the key.
As with most things in life, applying the KISS principle to trading is generally a good idea. If you are the only one that has spotted a pattern, nobody is acting on it, making it less likely that it will repeat. Ranges work because they are easily seen and often traded, creating points of support and resistance. Squashed frogs, on the other hand, have little practical use.