So… Why Exactly is Technical Analysis Important?

May 25, 2010: 4:41 PM CST

It’s days like this that the broader investing public learn the benefit of even simplistic technical analysis and levels to watch.

You don’t have to be a chart wizard to know key levels to watch that are likely turning points in a market.

Let’s take today’s S&P 500 Daily Chart for example:

Some people believe that stock prices are random – that no one can predict the future.  If you’ve lost money trading, you’re more likely to adopt that philosophy!

Usually the truth is in the middle – stock prices are neither 100% predictable/forecastable every single day, nor are they absolutely random or 100% unpredictable.

Why did the market rally so sharply today?

That’s because – love charts or hate them – everyone can see that 1,050 is a very important prior support level.  I called it the “Edge of the Cliff” in this morning’s update, and so far that has been correct.

How can I ‘predict’ that stock prices will rally off 1,050… or fall sharply if under 1,040?

That’s because investors and traders in aggregate – or at least enough – watch these levels so as to make them, in essence, self-fulfilling prophecies.

Large funds may decide to buy at a level where they feel comfortable ‘everyone’ will be buying, and those are usually at blatantly obvious chart levels.

In addition, those who are short-selling see the 1,040/1,050 area as a target that they are playing for, and thus TAKE OFF – or BUY to cover with a profit – their short-sold positions.

New bulls enter BECAUSE price is testing a known level while Old Short-sellers cover with a profit as price enters a key support level.

And the market goes up sharply.  We call this “Positive Feedback” (bulls buying; bears buying).

And those who were aware of these dynamics – and have access to intraday trading accounts – can profit very handsomely from this knowledge.

But what would have happened if the market broke through the 1,040 level today?

A nimble trader would have expected a bounce to occur today off such an important support level, but in the event that the market ticked down to 1,035 then 1,030, he or she would flip over to Plan B, which would include shorting a breakdown of a critical support area.

Think back to what happened initially when we broke under the first KEY support level at 1,150 – (which I posted “Here We Go – Make or Break at 1,150“) that was the day the flash crash occurred (no, it was no a singular fat finger).

I highlighted a similar, yet smaller, key level to watch on the rally back into the 1,150 level in “If the Market Will Turn Down, it will Do So Here.

A trader would anticipate the OPPOSITE feedback loop occurring, such that those bulls who bought at the 1,040/1,050 level expecting a bounce would then sell their new positions on a break under 1,040 which would simultaneously draw in new short-sellers looking to take advantage of a breakdown in the market.

This is ALSO a positive feedback loop with Bulls selling to stop-out (or hedge with short-positions) and Bears short-selling to enter new speculative positions.  And I suspect that we would have seen another sharp sell-off if we would have seen prices under 1,035 today.

So in conclusion…

That’s what being a trader is.  That’s why charts can be helpful.  A chart is not a 100% crystal clear roadmap to the future, but it does help you understand some of the dynamics and expectations between buyers and sellers / bulls and bears.

In watching key levels that everyone is watching, you can forecast reactions when certain levels are hit and triggered.

You won’t know which way the avalanche will fall… but at a critical level (and 1,045 was critical for more reasons than it was just the February low), you can take advantage of the expected Positive Feedback loop that develops once a key support level holds… or breaks.

The feedback loop can last a day, a week, or longer… but as a trader, it’s up to you to be quick and unbiased in your approach, willing to take advantage of which way the market – and its participants – break.

Corey Rosenbloom, CMT
Afraid to

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6 Responses to “So… Why Exactly is Technical Analysis Important?”

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