The pros and cons of a chartist trading strategy
Warren Buffett has dismissed trading by spotting patterns in charts yet it continues to hold allure for those looking for simple insights into how to invest
Is it possible to trade by spotting patterns in charts? Warren Buffett, the Sage of Omaha himself, had a simple verdict: no. He said, “I realised that technical analysis didn’t work when I turned the chart upside down and didn’t get a different answer.” He stuck to the polar opposite – fundamentals investing, where only the long-term financial prospects of a company are considered – and ended up the world’s richest man.
Yet so-called chartism remains popular. Legions of day traders swear by it. They track price movements with saucer bases, pullbacks, double bottoms and diamond bottoms; there are levels, breakouts and Fibonacci retracements.
So what’s going on? Is it really possible to trade solely by spotting patterns and trends in short-term market movements?
“I strongly believe that many people engaging in this type of trading do not know what they are doing,” says Dr Andrea Barbon, assistant professor of finance at Switzerland”s University of St. Gallen, who teaches a PhD course on mathematical modelling for finance.
“I have friends who have started trading. They call me and ask for advice. And they are really quite expert in these charts. But they don’t know what they are talking about. Software is attracting their attention. They are trying to extrapolate the future from what happened in the past. But it’s nonsense. It’s just emotional.”
And yet Barbon concedes there may be two reasons why chartism can deliver results. The first is the fact that so many people believe in the methodology. “Traders are all looking at the same charts and using the same indicators. And if people believe that when a price crosses a line then its the right time to buy stock, that will push the price up,” he says. Patterns in the charts thus become “co-ordination devices” for groups of like-minded traders.
The second justification is more substantial. “Charts at high frequency may capture arbitrage opportunities. There may be a big player who needs to liquidate a large position. When they do that they leave traces in the chart. It is possible to spot this, in principle,” says Barbon.
The need for simple insights
On the trading floors, you’ll find all sorts of opinions, from sceptics to devotees. One of the most popular places for traders to share strategies is TradingView, which claims more than 15 million visitors a month.
David Belle, TradingView’s UK director of growth, explains that for many traders, the appeal of charts is they offer simple insights. “You have to remember that trading is one of the hardest games in the world. And the way it is marketed by brokers makes it look easy. It can seem like a game. People think it should be accessible. So they see things and assume they have importance,” he says.
Often patterns they notice are phantoms. “It’s confirmation bias,” says Belle. “They look at the history of the S&P 500 and notice a correlation with the phases of the moon and say they’ll buy at the next full moon, when really there’s no causation at all.”
Samuel Leach, founder of Samuel & Co Trading, trader, trainer and social media star with more than 132,000 followers on YouTube, is blunt about the excesses of chartism.
“I’ve seen some that are really bad,” he says. “There’s one called the Gartley pattern, which looks like a butterfly or bat. I’ve seen people draw a duck around price action.”
But Leach says chartism can produce good results, if only because it’s popular. “If people are doing the same thing at the same time, then of course it’s going to work,” he says, noting that chartism is therefore more effective with smaller capitalisation stocks than major indices. “Foreign exchange markets are in the trillions traded. You aren’t going to have a noticeable effect on that.”
Leach uses chartism for his own trades. “I love fundamentals,” he says. “I say ‘I am going to buy this stock’. But when am I going to buy it? I use technical and support levels for that. If I can see a share is bouncing around between two levels, I can wait for it to hit the lower level before I buy.” Results are never guaranteed, but it would be odd not to take short-term movements into account.
Missing the early-mover advantage
Another reason to doubt the merit of chartism is the fees it incurs. Every time a trade is made a fee must be paid and over time these erode a significant proportion of the gains.
Furthermore, chartists underestimate the calibre of the competition. Investment banks deploy trading warbots able to execute high-frequency trades. These trading bots are programmed by highly paid quants with PhDs in mathematics and physics. It is fanciful to suppose a lone trader, equipped with basic trading tools, can win consistently against billion-dollar funds armed with this weaponry.
And chartists forgo the most obvious advantage to self-investing: taking advantage of new market information. An events-based strategist, for example, can scan breaking news for an event that will shake the market and move fast to take advantage. Chartists will see the ripples as they occur, but miss the early-mover advantage.
Chartism means rejecting some of the trading strategies with the best track records, namely diversification across funds and industries, and analysing fundamentals to look for under or overvalued stocks. It’s high risk to trade just a few stocks over the short term.
Evidence is emphatic. Researchers at Brazil’s São Paulo School of Economics and University of São Paulo, tracked 1,551 retail investors with more than 300 days of trading each. The result? Only 1 per cent earned more than the Brazilian minimum wage and 0.5 per cent more than a bank teller, and all incurred with great risk.
“We show that it is virtually impossible for individuals to day trade for a living,” the researchers warn. The more investors traded the worse they performed: “The probability of an individual exhibiting a positive profit monotonically decreases with the number of days he or she trades.”
Beware of the serial winner
The explosion in popularity of trading via apps and easy-to-use websites means chartism is flourishing. The situation is amplified by charismatic figures who brag about easy wins via formulae. One of these traders, Alex Hope nicknamed King Popper, was sentenced to three years in jail for masterminding a £5.5-million Ponzi scheme from gullible investors. The sad truth was Hope had no expertise in trading. He was sentenced to an additional 16 months for blowing funds on prosecco and concert tickets rather than repaying his victims.
Even the BBC gets fooled. An episode of Young, Welsh and… on BBC Three featured a 20-year-old online trader said to make up to £200,000 a year on foreign exchange markets. In fact, he was merely a marketer flogging expensive courses. The episode was later pulled from iPlayer.
Barbon warns: “A very good friend paid $5,000 for an online course to follow this guy’s classes. I mean, this guy is selling bulls**t.” The rising market means his friend is in the black and could be excused for feeling invincible. Chartists are notoriously confident in rising markets.
As the Sage of Omaha put it: “Only when the tide goes out do you discover who’s been swimming naked.” In a bull market everyone looks like a genius. When the bears return then we see whose methods are valid. Only then will chartists discover the true power of their Bollinger bands and rising wedges.