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Hey, his is Sasha Evdakov and welcome to another episode of let’s talk stocks, episode number 95, in this week’s episode I ask the question of does technical analysis work? And why does it work?
For some of you who are a little more skeptical about technical analysis or are just getting into technical analysis, I want to share with you the concept of technical analysis and why it really kind of works out in the favor or the trade or in favor of the stock movements and the way that they move.
In general, when we look at investing, we’re looking to put some money into something, and then, in the end, we hope to get back more than what we put in. Whether that’s two times, three times, four times, five times, whatever it is.
You put a certain amount of cash into an investment, and you hope to get more money out of it through a passive means, or appreciation, through dividends, through other methods, so this could be through stocks, it could be through buying antique cars and holding on to antique cars, there’s a lot of forms of investing. In either case, you put some money in, and you hope to get more money out later.
There’s a couple of ways to do this when you’re looking at stocks, and one of the ways, one of the more common approaches is through fundamental analysis. So with structural analysis, you’re looking at company health.
When you look at company health, you’re looking more along the lines of the balance sheet, for example, things like how are the company earning its money, are the earnings increasing? How are the product sales? How are the active users? What are they spending money on?
For example, if their spending is greater than the money that they’re making, that’s probably a bad sign, but if they’re using it to invest and grow their product line, then it might be ok.
But in either case, you’re looking at a baseline of how the company’s health looks under the company itself. How the company operates, so that’s fundamental analysis.
And this is the way most people approach investing in stock; they’re looking at a company’s health. If you have seen the show Jim Cramer’s mad money, he’s more of a fundamentalist. He’ll look at things more on a fundamental basis on a company scope.
The second approach to investing is you’re looking more at technical analysis, which is what we’re talking about. And with technical analysis, you’re looking to predict future prices, based on two main things, and that is price history, and volume. Those are the main factors.
A lot of the other things that go with technical analysis are based upon the price and the volume. So even if you look at MACD, stochastics, moving averages, all of those things are based on the price and the volume.
That’s why I emphasize a lot of price and volume, if you look at some of my charts and my other recaps about trading, a lot of it has to do with price and volume. Because if you understand price and volume, you can use the other indicators as well, because they all stand and drive things from that.
The goal is the same
But in either case the goal is the same, whether you’re looking for technical analysis or you’re looking at fundamental analysis, the goal is still the same, you’re taking the money, and you’re investing it, and you’re hoping to get more money at some time at a later date.
A lot of people can understand why fundamental analysis works, because if you have accompanied that’s in good health, if you have a balance sheet that’s in good standings, if you have great active users, good revenue coming in, if they’re spending less than what they’re making, and the company is growing, then it’s easy to see why that company, those earnings would increase in the future as well.
With technical analysis, because it’s not something we’re typically used to, as we grow up as a child, into adolescence and then into the mid-20s and so forth, we’re not always aware of how technical analysis plays a role.
Does technical analysis work?
It’s something that we as stock traders get put into, and we are aware of this concept, and then it’s put into our lap, and then we wonder why does it work? And does it actually work?
From my standpoint, it does work, and the reason for that, the central core of why technical analysis works is because of crowd behavior, crowd psychology and the law of supply and demand.
If you want to take a look a little bit more about the psychology of how things work and evolve, there ‘a really simple and easy to understand video, it’s called, “The first follower” and you can look it up on YouTube, and it’s basically a guy that’s dancing at this park.
It’s really about a lesson on leadership. Search for it on YouTube, and it’s got millions of views. But really what happens in this video, and I’ll explain it on a timeline.
If we look at a timeline, what happens in the video is we have this going from one minute to 5 minutes.
Initially what happens is, there’s a guy that’s dancing out there. So initially he’s just the first one, that’s him just dancing wild, crazy, whatever, he’s doing his thing, he’s dancing out on the field.
Eventually, with time, he gets a second person, which is the first follower, hence the name of the video.
Over time again a little bit later, you have a mother person joining in, so now you have those two people, plus you have a third person, which backs up that first follower.
After a while this continues to grow, so now people feel more comfortable, it’s kind of like social proof that happens online. So now you have a group of people that joined in, maybe two or three people.
And this kind of continues, until eventually most of everybody else joins the party, and you have now a more significant group and people joining in, and then more and more people continue to participate until pretty much everybody at the party, or everybody on the field, mostly everybody actually goes up and starts dancing. They’re not worried about it.
Supply and demand
When you’re first initially getting started, it’s tough, it’s difficult to move that stock, and then eventually you have another person that comes into fuel that stock, then more and more people start to come in and more and more people come in as they start hopping into the stock, and the stock keeps moving.
The way that this works is due to the supply and demand. So what is demand? Demand is buyers. Supply are sellers.
Sellers are selling the stock, buyers are buying the stock, so as you have one person coming in, he’s a buyer, but initially that stock, if you look at a chart, initially that stock starts to kind of move to the upside.
You have that one initial buyer, and it’s not a lot of buyers, it’s just one buyer. So it starts to move up, and when you get the second person, now you get maybe, this one might be just a scalper.
Then the second buyer, or a few more buyers, so you can multiply this times, let’s says 100 people or 100 shares, or 1000 shares, depending on the stock that you’re trading.
First, you’ll get the scalpers coming in and the day traders, and then you might get some more value buyers coming in. So this would be somewhere on the second stage, you got value buyers stepping in.
Then you go again, a couple more people start coming in, you got social proof, this stock is starting to head higher, looks to be like there’s momentum, there’s the fuel behind the stock, so you have again, more people coming in.
There’s not enough space for everybody
This continues to go and move up until you get to a certain point, where this kind of starts to top off because it starts to look little stretched.
If you’re dancing in a little room, there’s only so much space that there is on the dance floor. So when some people leave the dance floor, then you can step in and get on the dance floor, because there’s only so much space.
Same thing if you have a line at a wedding for getting food, they usually release you table by table to get your food, so as you have people coming in, and you have the tables over here and all these different tables, they might have table one and two go, and then later you have table three and four go, and that is only because there’s just an abundance of food, but there’s not enough space. There’s not enough space to have everybody go through.
That’s the thing if everybody is jumping in right away, it’s going to fuel that stock, it’s going to be crazy, it’s going to spike big. And what does that mean? Well, how does that proof come in?
It’s due to the volume, so as you start looking at it. Initially, you might have a small little volume spike, later as you continue, that volume spike might grow even more significant.
As more people come in, they fuel that stock, and then again, you get even more volume that will come in. And this creates a proof within that stock, within the stock that’s moving.
As that stock starts to pull back, and as we come back into this price level because as this line opens up or the dance floor opens up, as we have an opening in space, that volume might start to get weaker.
As that volume gets weaker, that’s good, that’s healthy, that’s a normal pullback, because now the space opens up, now the prices are not too high, then you have more value buyers stepping in, scalpers coming in, day traders, swing traders coming in, and they say, ok, this level is a good buy.
So then what happens to the stock again? Well, again, the volume starts to pick up, and then when the volume picks up, that stock continues to head higher.
You can see the volume much more significant than before when you compare these two volumes, it’s a lot lager, and that’s what continues to fuel the stock.
Stock movement is based on crowd behavior
What does this mean? This means that a stock is different for everybody at various points, and it’s all based on that crowd behavior. Some people, like if we look at this person over here won’t join in until later, until the bounce, until this price level right here, until that stock bounces.
Other people might be all the way over here. They might be the early people, so for you, you’re looking at the crowd behavior, the crowd psychology, how is that stock moving based on the crowd?
The issue here is when we have this support and resistance, how it’s being created, is again, if there are enough people that are willing to step in on the dance floor or still enough people to get food, then that food will always be there, the dancing will keep happening.
But the minute there’s not enough people, with crowd behavior, the minute the people get tired of dancing; the people don’t want to get any more food, because there are not more people, that stock will continue selling off.
The volume will give you signs
This is when you look at the volume it’s going to tell you some key sings. So if you start seeing more selling, if you start seeing larger volume as that stock is selling off, that’s why volume is important, it’s the number of shares traded. As you start seeing that and that stock rolls over, that’s where that support is going to break.
The same thing happens on the resistance level, so if you see it selling off substantially at a resistance level, then again, you’re looking at the volume, and if volume confirms that, you’ll see it selling off further.
But it comes down to the key principle here, the key point is this social and crowd behavior, it’s all about the buyers and the sellers.
It’s probably really simple for you to evaluate a dance floor, so for looking here at a dance floor to see, ok, when are people getting tired? Or based on the song, when they’re going to sit down at a wedding. Or when you look at the food, the amount of food that’s left or remaining, and the number of tables that still have to get their food.
It’s easy for you to see that, because you’ve seen in happen, it’s something you deal with on a day to day basis. You look at the food, and you see what’s left over for your family, for yourself, how much leftovers you’re going to have for tomorrow.
And the same thing if you go to a wedding or a buffet or the amount of space or sitting there is at a seminar, or at a restaurant, if they’re full, you’re going to have to wait, because they only have so many tables and once somebody leaves, then another person comes back in. The volume, the number of people that are sitting here waiting to go in, is going to continue fueling that restaurant.
The same thing here, when we’re looking at a stock, if there are people still coming back into the restaurant, it’s going to fuel it higher. And then a person or two or some people leave, then again, more people will come in because there are still buyers on the sideline. There are still people looking to get in at those different time slots. And then again, people are leaving.
But once it hits, let’s say 11 o’clock at night, or something like that, everybody is out, they are gone, they want to go home, they want to go to sleep unless it’s a club.
But otherwise, at midnight, think of it like Cinderella, they’re gone, they’re out, and that’s when the selling takes place.
This concept you can look at it from an intraday standpoint, meaning it happens on an intraday basis, it happens on a daily basis, a weekly basis, a monthly basis, and the longer the timeframe you’re looking at, the more concrete the support and resistance line is.
It’s all about human behavior
All of these things, when we look at the price action, when we look at the movement of the stock, comes down to this, comes down to the crowd behavior, the psychology behind it, it’s all about human behavior.
And it works, and that’s why the support and resistance work because people come in, they want to value by. Or you go to a restaurant, and you love that place, are you willing to wait 5 minutes to get a sit or 10 minutes?
Probably because it’s not worth it to go someplace else, it’s not worth the time or effort or energy because you’re hungry.
Same thing here, you’re hungry for an investment, to make cash, to make money, to do something with your money, so you’re looking at a good entry point, you get in, something that’s reasonable, reasonable price, and that’s what continues to move the stock.
That’s how it works, and all these patterns, no matter what pattern you’re looking at, whether you’re looking at triangle patterns, support and resistance, which are the basics when you look at those, it’s all about that crowd behavior, the crowd psychology.
You’re looking at value, Fibonacci, the same thing, when a stock sells off 50%, typical retracement as I always like to say, it’s 50%, and nothing is wrong with the stock.
If you have a stock that’s up here, and it went all the way from here to here, and it pulls back to 50%, there’s nothing wrong with that stock because then it can continue to bounce and move higher, because now you have people coming in at a value.
They want to get that investment. And that’s how all of this technical analysis works. And this is why it works; it’s because of the crowd behavior and the crowd psychology.