One of the great aspects of our new Certified ChartWatchers exam is that we get feedback as to which questions people are struggling with. Clearly, those are the questions that point to aspects of Technical Investing that we need to do a better job educating people about.
For example, one of the questions that many people are struggling with asks about the Key Assumptions of Technical Analysis. Those are the three things that you must verify are true before you can apply standard chart and/or indicator analysis to a particular chart. Here they are:
1.) High Liquidity -
Liquity is essentially volume. It means that shares have the ability to trade quickly without dramatically affecting prices. If someone buys 100 shares of Microsoft today, that trade by itself will have almost no effect on the price of the stock. Why? Because MSFT is extremely liquid with lots of buyers and selling at any given moment.
Low Liquidity is a trap that many amatuer investors can fall into. When you buy a stock with low liquidity, you probably won't get it at the price you were quoted because there are no sellers at that price. The broker has to raise the price - often significantly - before a buyer can be found. Similarly, when you sell a low liquidity stock, the broker will need to lower the price significantly to find a seller.
In addition, low liquidity stocks are often very low priced - often less that 1 cent - and that means that their price can be manipulated by someone with lots of resources (and lots of time).
None of what I just said is illegal or hidden or "wrong" in any way. It is just that the principles upon which Technical Analysis is based assume that only normal market forces move a stock's price - not the manipulation or issues with trading volumes that low liquidity stocks can have.
2.) No Artificial Price Changes -
Similar to the reason for high liquidity, prices cannot be changed by forces other than the fear and greed that drives the market. Anything else that changes prices is considered "artificial" and needs to be eliminated before standard technical analysis techniques can be applied.
So what is an example of an "artificial" price change? Splits, dividends and distributions are the most common "culprits." When a stock splits, let's say 2-for-1, the market participants don't really care. They get double the shares at half the price - a net-zero transaction that doesn't change their opinion of the stock one way or the other.
However, consider what happens to the stock's chart. It now has a huge (50%) gap down on it. If you didn't know about the split, you'd be very worried about the stock. And, because technical indicators are dumb, they would all give bearish "sell" signals at that point.
For this reason, the effects of these "artificial" price changes must be removed from the data before standard technical analysis techniques can be used. Ironicly, this is done by adjusting all of the data prior to the split downwards thus eliminating the gap on the chart.
3.) No Extreme News -
Technical Analysis cannot predict extreme events such as, for example, a company's CEO dying unexpectedly or the huge tragedy of 9/11. When "extreme news" happens, technicians have to wait patiently until the chart settles down and starts to reflect the "new normal" that results from such news.
Now, again, it is important to understand that I'm not saying that charts are useless when one or more of those three things occur. What I am saying is that the philosophical underpinings of the signals and chart patterns that traditional technical analysis uses are gone on those cases. Standard technical signals and predictions cannot be accurately used in those circumstances.
For more on the underpinings of Technical Analysis, see our ChartSchool articles on the topic by clicking here.