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Investment Philosophies: Successful Strategies and the Investors Who Made Them Work, 2nd Edition by Aswath Damodaran

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CHAPTER 7

Smoke and Mirrors? Price Patterns, Volume Charts, and Technical Analysis

Some investors believed that price charts provide signals of the future, and pore over them looking for patterns that will predict future price movements. Notwithstanding the disdain with which they are viewed by other investors and many academics, easy access to data combined with an increase in computing capabilities—charting and graphing programs abound—has meant that more investors look at charts now than ever before. In addition, data on trading volume and from derivatives markets have provided chartists with new indicators to pore over.

In this chapter, we look at the basis of charting by examining the underlying premise in charting and technical analysis, which is a belief that there are systematic and often irrational patterns in investor behavior and that technical indicators and charts provide advance warning of shifts in investor behavior. While we will not attempt to describe every charting pattern and technical indicator (there are hundreds), we will categorize them based on the view of human behavior that underlies them. In the process, we will see if there are lessons in charts that even nonbelievers can take away and cautionary notes for true believers about potential inconsistencies.

RANDOM WALKS AND PRICE PATTERNS

In many ways, the antithesis of charting is the notion that prices follow a random walk. In a random walk, the stock price reflects the information in past prices, and ...

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