Technical Analysis of Stock Prices
I recently stumbled upon the most recent (Winter 2019) issue of Charles Schwab's “On Investing” magazine, which contains a wide variety of investment advice, most of which is fairly generic (i.e. not tailored to Schwab's products). There were parts of it that I really appreciated, like Carrie Schwab-Pomerantz's notes on spousal benefits for Social Security and Chris Kawashima's article on Employer Stock Options.
However, I am most glad to have read Lee Bohl's section on Bollinger Bands and how they're used in so-called technical analysis of stock prices. Perhaps this is the anti-thesis of that section, because I now feel more convinced than before, that the so-called technical analysis is really no better than the buy-and-hold strategy, or better yet, dollar-cost averaging, in which you periodically invest a certain amount, regardless of the current market performance. In a sense, I now feel that the stock broker throwing jargon at me or showing me complex plots doesn't really use any hard science or logic or math to come up with the “winning strategy”.
So that's the purpose of this post — to point out that you and I can be just as equipped (or unequipped) to make sound decisions, as compared to the broker.
At its core, you are said to be using Technical Analysis when you analyze trends in the stock price to determine when to buy or sell. Effectively, technical analysis implies the use of charts and other metrics based on the movement of the stock. As a counterpart, there's Fundamental Analysis, where you use information outside of just the movement of the stock price, such as balance sheets, economic conditions, etc.
This brings us to the Bollinger Bands, a chart that is used often in technical analysis. Here's my (very crude) illustration of a Bollinger Band plot.
The plot has time on the horizontal axis and stock price on the vertical axis. It shows a set of vertical bars, often colored red or green, and two lines that usually surround the vertical bars, shown here in blue and orange. The vertical bars in the center of the plot show the moving average of the stock price over a specific time frame. It's often colored green or red depending on the overall movement of the stock price. The two bands above and below plot twice the standard deviation.
That's all there is to the content of the plot. The next, and more important, question is how to interpret these lines and shapes.
Luckily, the way brokers interpret the Bollinger plots is no more difficult than common sense. The key is to look for patterns that amplify the signal in the noise. For instance, if the outer bands stray too far from the vertical bars, then the stock price is highly volatile (duh!), and so you should exercise caution before buying (and perhaps selling) the stock. On the other hand, if the outer bands are too close to the vertical bars, then it's likely that the stock price might change in the near future, in which case you look for significant positive movement to decide whether to buy or significant negative movement to decide whether to sell. If your goal is to capitalize on the change, you need to act soon but not so soon that you decide before there”s an actual trend. The moving average helps to boost the signal-to-noise ratio, while the standard deviation amplifies the movement of the stock price.
My point is, “technical analysis” isn't a radically ground-breaking idea. It is, in essence, a set of statistical techniques whose roots can be traced to common sense. Unfortunately, however, the minor fluctuations that technical analysis tries to identify are, I think, too difficult for statistical analyses to predict accurately. So while the Bollinger Bands may tell you that you see a “W” (i.e. the stock price has dipped twice), so this is the right time to buy before it shoots up, there is no certainty whether the stock price will dip again, or whether the “W” shown in the Bollinger plot is merely a blip in a much bigger “V”.
Absurdly enough, there's an investment approach called Bollinger Counter Trend Trading, where you do the opposite of the action recommended by the Bolling Bands, with the expectation that the trend will reverse. The Wikipedia entry contains some citations of studies that showed the benefit of one strategy over another, but neither approach is a clear winner.
So in summary, don't fret the next time you see one of these charts. We're all humans, and we're all trying to make sense of a complex world, wherein you are perhaps just as unqualified as anyone else when it comes to predicting the future stock price.