Charts: Forecasting Tool or Folklore?

Common sense is not so common.


There is a story about a speculator whose desire to be a winner was intensified by each successive failure. Initially he tried basing his trading decisions on fundamental analysis. He constructed intricate models that provided price forecasts based on an array of supply/demand statistics. Unfortunately, his models’ predictions were invariably upset by some unexpected event, such as a drought or a surprise export sale.

Ultimately, in exasperation, he gave up on the fundamental approach and turned to chart analysis. He scrutinized price charts, searching for patterns that would reveal the secrets of trading success. He was the first to discover such unusual formations as shark-tooth bottoms and Grand Teton tops. But alas, the patterns always seemed reliable until he started basing his trades on them. When he went short, top formations proved to be nothing more than pauses in towering bull markets. Equally distressing, steady uptrends had an uncanny tendency to reverse course abruptly soon after he went long.

“The problem,” he reasoned, “is that chart analysis is too inexact. What I need is a computerized trading system.” So he began testing various schemes to see if any would have been profitable as a trading system in the past. After exhaustive research, he found that buying cattle, cocoa, and eurodollars on the first Tuesday of months with an odd number of days and then liquidating these ...

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