The pros and cons of a chartist trading strategy

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.