Latest / How Canadian Markets Work / Episode 80: Reading a Chart (The Discipline of the Limit)

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Episode 80: Reading a Chart (The Discipline of the Limit) · How Canadian Markets Work

0:00
In our last deep dive, we spent, well, pretty
0:03
much all our time looking deeply under the hood
0:05
of a business. Right, getting into the real fundamental
0:07
mechanics of it all. Exactly. Tearing apart industry
0:11
structures, competitive modes, and barriers to
0:15
entry just to figure out what a company is truly
0:18
worth. And think of it this way, analyzing a
0:21
company's balance sheet and market share is a
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lot like trying to judge a restaurant by reviewing
0:27
a supplier invoices. Yeah, or like checking the
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quality of the raw ingredients in the fridge.
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Right. And interviewing the head chef. You are
0:35
doing this intense fundamental deep dive, but
0:38
looking through the stack of financial research
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and trading manuals we've gathered for today's
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mission. Which is a pretty massive stack, by
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the way. It is, yeah. But there's this totally
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different approach to the market in these sources.
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What if you ignored the food entirely and just
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bet on the restaurant because the line outside
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is getting longer every single day? It's a radically
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different way of processing the world. I mean,
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you go from being a mechanic inspecting every
1:00
belt and valve to being, well, a meteorologist.
1:04
The meteorologist, right? Yeah. You are just
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reading the wind and the pressure systems and
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you are ignoring the cars entirely. The fundamental
1:11
analyst is analyzing the product, but the technician
1:14
is strictly analyzing the crowd. And so today
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we are taking a deep dive into the deeply controversial
1:21
world of technical analysis. The religious war
1:25
between fundamental analysis and technical analysis
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is, well, it's one of the oldest in finance.
1:30
Oh absolutely. The fundamentalists are the ones
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calculating intrinsic value, buying a stock they
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think is cheap and just waiting for the market
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to eventually agree with them. But technicians,
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on the other hand, they study price and volume
1:42
history. Right, and a pure technician argues
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they don't even need to know if the company sells
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software or steel. The chart is literally the
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only data that matters. Which explains why the
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fundamental analyst thinks this is completely
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absurd. I mean, how can you confidently invest
1:56
capital into a business without actually looking
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at what the business does? Or what debt it holds,
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who its competitors are, yeah. Exactly. But the
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technician's focus on the crowd rests on a few
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core premises. And the most provocative one from
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our sources is this idea that price discounts
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everything. Right. Reading through these manuals,
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I got to say that is the most arrogant claim
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the chartists make. They operate on this idea
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that every single piece of information out there,
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even the stuff the public doesn't know about
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yet, is already baked into the price. It sounds
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arrogant, sure. But the logic behind it is actually
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quite fascinating. The argument is that all information,
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including secret private information that hasn't
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been publicly disclosed, eventually ends up expressed
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in price and volume long before it hits the news
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wires. Okay, give me an example. Well, let's
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say a CEO is quietly dealing with a major catastrophic
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supply chain crisis. The public filings look
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great, right? The last earnings call was wildly
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optimistic. Everything looks fine on paper. Exactly.
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But internally, things are falling apart. So
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insiders, suppliers, or people adjacent to the
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company might start quietly de -risking. They
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start selling. Ah, I see. So the fundamental
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analyst is flying completely blind here, just
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waiting for the next quarterly report. Yep. But
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the technician doesn't need to know about the
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missing shipping containers. They just need to
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see the sudden unexplained selling pressure showing
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up on the chart. Precisely. The chart acts as
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a footprint. The technician argues that, you
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know, by the time the fundamental analyst reads
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about the supply chain crisis in the Wall Street
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Journal, the stock has already dropped 20%. Wow.
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So the information was already discounted into
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the price by the people who knew first? Right.
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And that brings us to the next massive assumption
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in technical analysis, which is that prices move
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in trends, and more importantly, that history
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repeats itself. Because the whole discipline
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relies heavily on human psychology, right? Exactly.
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because human beings respond to situations of
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fear, greed, and panic in very predictable patterned
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ways. So the physical patterns they create on
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a price chart supposedly don't change either.
4:03
Humans are the constant in the equation. Okay,
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let's unpack this. This behavioral aspect leads
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us directly to the foundational building blocks
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of chart reading support and resistance. The
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invisible floors and ceilings. Right, you constantly
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hear traders talk about these. Support is the
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floor where buying repeatedly emerges to stop
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a stock from falling. Resistance is the ceiling
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where selling repeatedly emerges to stop a stock
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from rallying. But I've always struggled with
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this concept. Why is that? Well, why would an
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arbitrary number say a stock hitting exactly
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$40 a share act as a magical barrier? It feels
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like superstition to me. Why 40? Why not 39 or
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41? I get that. It feels arbitrary until you
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look at the cognitive dissonance of the investor
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who's actually holding the bag. It is entirely
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driven by memory and regret. Memory and regret.
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OK, walk me through that. Let's walk through
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a highly relatable scenario for, well, probably
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everyone listening. Imagine you buy a stock at
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$40. The narrative is great. You feel confident.
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Doing great so far. Right. But two days later,
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earnings miss, and the stock immediately plummets
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to $30. Oh, man. Man, a gut -wrenching feeling.
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You're down 25 % instantly. It's brutal. And
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you spend the next six months staring at that
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red number in your portfolio. You are just kicking
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yourself. You go through the bargaining phase
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of grief, essentially. Oh, I've been there. We
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all have. You tell yourself, if this thing can
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just crawl its way back to $40, I'm selling it.
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I don't even want to profit anymore. I just want
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to break even and get this stress out of my life.
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So the $40 mark isn't a magical force field.
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It's a... graveyard of regretful buyers trying
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to escape. That is a perfect way to put it. So
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slowly, the stock climbs back up 35, 38, 39.
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The moment it touches $40, you and thousands
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of other people who have been trapped in that
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exact same psychological pain all hit the sell
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button at the exact same time. Wow. The overwhelming
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relief of breaking even creates a massive wave
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of supply. That sudden flood of sell orders physically
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stops the price from going any higher, creating
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sudden resistance at that old peak. Because everyone
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just wanted out. Exactly. The ceiling exists
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purely because of human trauma and memory. That
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makes total sense. But there's also an element
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of a self -fulfilling prophecy here, isn't there?
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Because if enough market participants simply
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believe that $40 is a major resistance level,
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they will all place their sell orders right there
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just to get out ahead of the drop. They literally
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will it into existence. Yeah. If enough people
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believe a line on a chart matters, they transact
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around that line and their transactions make
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the line matter. massive feedback loop. So if
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everyone is watching that $40 ceiling and the
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price keeps hitting it and getting knocked back
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down, it starts acting like a coiled spring,
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right? Yes, exactly. Because the more times the
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price hits that floor or ceiling and bounces,
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the more tension builds up in the market for
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when it finally breaks. That tension is such
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a crucial concept. When a stock hits a resistance
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level multiple times, short sellers start stepping
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in. They're betting it will fail again. So they
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place their stop losses just above that $40 mark.
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Right. If the stock finally has the underlying
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strength to push though to 41, all those short
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sellers are suddenly trapped in losing positions.
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Oh, and they have to buy to cover. Exactly. They
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have to buy the stock to cover their shorts,
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which creates this explosive surge in demand.
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That's why breakouts from long established support
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or resistance levels are often so incredibly
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violent. The spring uncoils. But knowing where
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a stock might bounce. is uh... kind of useless
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if you don't know the wider context of the market's
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momentum, which is why technicians rely heavily
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on moving averages to filter out the daily noise
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and find that baseline trend. The moving averages
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smooth everything out. Right. But the inherent
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flaw I see here is that moving averages are,
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by definition, trailing indicators. I mean, you
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are always acting on old data. Are these crossovers
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actually predicting anything, or is it just a
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rearview mirror? It is absolutely a rearview
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mirror. And that is the ultimate trade -off in
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technical analysis. early entry for confirmation.
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Okay, so you're waiting to be sure. Right. A
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moving average smooths out the chaotic day -to
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-day fluctuations, so you can see if the overall
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tide is coming in or going out. It tells you
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what has happened. But you are absolutely right.
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When you wait for a 50 -day moving average to
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cross over a 200 -day moving average to signal
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a new uptrend, well, you have already missed
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the first 20 % of the move. And this is where
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volume comes in as a sort of lie detector for
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the chart, right? A lie detector is a great term
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for it. Volume is the institutional footprint.
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Look. Retail traders simply do not have the capital
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to move the needle on a multi -billion dollar
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company. We just don't have the cash. No, we
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don't. So if a stock breaks through our theoretical
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$40 resistance ceiling, you look straight down
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at the volume bars. If it breaks out on unusually
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heavy, massive volume, that tells you the big
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mutual funds and hedge funds are stepping in.
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The big money is participating. That is a highly
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credible move. But if it drifts above $40 on
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incredibly light volume? It's a trap. A total
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trap. It means nobody with real money is participating.
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And the moment a real seller shows up, the price
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is just going to collapse right back under the
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ceiling. It's a false breakout, yeah. Volume
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confirms the conviction of the price movement.
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If there's no volume, there's no conviction.
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Now, we really need to talk about momentum because
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the academic literature we reviewed actually
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concedes that momentum exists. This broad tendency
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for recent winners to keep winning and recent
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losers to keep losing over intermediate timeframes,
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like usually 3 to 12 months. Yeah, the data is
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pretty clear on that. But they often seem to
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punt on why it works. If it's not just a magical
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predictive shape on a chart, what is structurally
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driving a stock to just keep going up? Well,
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the behavioral and structural theories behind
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momentum are some of the most compelling research
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in modern finance. One of the leading theories
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is the slow diffusion of information combined
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with behavioral anchoring. Behavioral anchoring.
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Yeah. When a company reports an absolutely massive
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unexpected jump in earnings, analysts and investors
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don't immediately update their models all the
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way to the new reality. They anchor to their
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old valuations. They upgrade the stock just a
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little bit. They underreact. They don't want
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to look foolish by changing their mind too quickly.
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Exactly. The market slowly digests the magnitude
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of the news over several months. People buy in
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waves as they finally accept the new reality,
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and that creates a sustained upward trend. And
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there are structural institutional reasons too,
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right? Things that force fund managers' hands
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regardless of what the chart looks like. Oh,
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for sure. Window dressing is a perfect example
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of that. I love this concept. It's so real too.
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At the end of a quarter, portfolio managers have
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to pub - their holdings to their clients. Nobody
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wants to be caught holding the biggest losers
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of the year, so they dump the bad stocks and
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buy the stocks that have been tearing upward.
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Just so they can show clients, look, we own the
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winners. Exactly. That forced institutional buying
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creates a structural tailwind that pushes momentum
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stocks even higher. And conversely, tax loss
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harvesting at the end of the year forces investors
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to sell their losers to offset capital gains,
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which artificially pushes the losers even lower.
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So we have the psychological floors of support
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and resistance, the institutional footprints
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in volume, and the structural tailwinds of momentum.
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I mean, it all sounds incredibly robust and logical.
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It does. But here's the brutal truth we have
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to address based on the academic evidence. Anyone
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can pull up a chart of the last five years, draw
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some lines, tweak some parameters, and build
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a strategy that would have made them rich. Right.
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In hindsight. Exactly. It's like betting on a
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horse race after you already know who crossed
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the finish line. The academics call this curve
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fitting, right? Curve fitting is the quiet destroyer
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of almost every algorithmic trading strategy
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ever pitched to a retail investor. It's dangerous.
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Let's walk through how this trap actually works.
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A quantitative analyst sits down with a massive
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data set of the last 10 years of market history.
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They build a model using moving averages and
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volume breakouts. They run the back test. And
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the model shows it would have lost money in 2018.
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So they just tweak the rules. Yeah, they look
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closely at 2018 and realize, hey, if we change
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our 50 -day moving average to a 53 -day moving
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average and we only take trades on Tuesdays and
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Thursdays, the model magically dodges the 2018
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crash. Oh, wow. They run it again. Now it looks
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flawless. But they've essentially memorized the
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answer key to the past. They created a bespoke
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suit perfectly tailored to fit historical noise.
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But the future never looks exactly like the past.
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Exactly. When they deploy that beautifully curve
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fitted model with real money and the real out
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of sample future, it just implodes. The 53 -day
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average was just statistical noise. It wasn't
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a structural edge. Which highlights a broader
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cognitive trap for anyone looking at a chart.
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Finding patterns in stock charts is exactly like
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seeing faces in the clouds. Yes, apophenia. Right.
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Humans are biologically wired to find patterns
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in completely random data. I mean, we evolved
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to spot the tiger in the tall grass. Our survival
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depended on aggressively connecting the dots,
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even when the dots were just wind rustling leaves.
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They can't help it. We really can't. So when
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we stare at random chaotic price fluctuations,
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our brains desperately want to impose order.
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We see head and shoulders patterns and cup and
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handle formations because the pattern isn't in
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the data. The pattern is in us. We are projecting
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our own desire for predictability onto a completely
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chaotic system. And, you know, even if a chart
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pattern genuinely does represent a temporary
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behavioral edge, the very act of discovering
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it usually destroys it. The popularity problem.
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This is the efficient market hypothesis in its
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most practical form. Let's say a specific chart
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pattern genuinely works and a group of traders
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starts making consistent money off it. Word gets
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out. Of course it does. People write newsletters
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about it. Soon, everyone knows that a stock bounces
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predictably when it hits the specific technical
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setup. Right. And if everyone knows the stock
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bounces at 40, people aren't going to wait for
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40. They start buying at 41 to get in ahead of
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the crowd. And then someone else buys at 42 to
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get ahead of them. That aggressive anticipation
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pulls the buying pressure forward, entirely warping
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the original pattern. The competition to exploit
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the edge completely erases the edge. So if the
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predictive power of these charts is mostly a
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mirage, if the backtests are just curve -fitted
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illusions, and any real edge gets destroyed by
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its own popularity, you listening might be wondering
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why we are spending this entire deep dive analyzing
14:48
technical analysis. If it doesn't actually predict
14:51
the future, why bother? Because technical analysis
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has a secret superpower that has absolutely nothing
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to do with predicting the future. OK, I love
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this part. Its true value lies in execution and
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disciplined risk management. Let's compare the
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fundamentalist's ego trap to the technician's
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discipline. We use a concrete scenario. You spend
15:09
weeks reading financial statements, analyzing
15:11
competitive moats, and you evaluate a stock to
15:14
be fundamentally worth $50 a share. A classic
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value play. Right. You're just trading at $40.
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So you buy it. Then the market starts selling
15:22
off, and your stock drops to $30. And here is
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where fundamental analysts often get into trouble.
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They lack a concrete exit plan. Their intrinsic
15:31
value calculation tells them they are right and
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the market is wrong. So when the stock hits 30,
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they stubbornly hold on. They might even buy
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more, arguing it's just getting cheaper. Oh,
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they almost always do. When it drops to 20, they
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pound the table, insisting the market is entirely
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irrational. They get married to their thesis
15:49
and they can hold that falling knife all the
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way down to zero. Their ego is completely tied
15:55
up in being right? But the technician operates
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within an entirely different framework, mainly
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because they never cared what the company was
16:02
inherently worth in the first place. The technician
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decides in advance exactly what price level proves
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their thesis wrong. They use the chart to set
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rigid and flexible stop losses in advance. Yes.
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If they buy a 40 looking for a bounce off support,
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they decide right then and there. If this drops
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below 38, the pattern is broken. I am wrong and
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I am out. They don't hesitate. When the stock
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hits 38, they don't average down. They don't
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write a blog post about how the market is wrong.
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They sell. They take a tiny, manageable loss
16:31
and move on to the next trade. This is the single
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most critical takeaway from all the source material
16:36
we reviewed for you today. It forces you to admit
16:40
when you are wrong before a small loss because
16:43
a catastrophic one. You must decide your exit
16:46
strategy in advance when you are calm, rational,
16:50
and objective. because trying to make a rational
16:53
decision while your portfolio is bleeding out.
16:56
And your fight or flight response is fully activated?
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Yeah, it's neurologically impossible. The chart
17:00
converts a crisis decision into a pre -planned
17:03
execution. It removes the emotion from the hardest
17:06
part of investing, which is admitting defeat.
17:09
That is the strongest argument for the discipline
17:12
of technical analysis. It enforces survival.
17:15
And beyond just survival, charts also have incredible
17:18
descriptive power for anyone holding a portfolio.
17:20
Oh, absolutely. Even if you assign zero predictive
17:24
value to a chart, pulling up a five -year price
17:26
and volume history tells you an enormous amount
17:28
about the reality of an asset instantly. What
17:31
kind of reality? It shows you the volatility
17:33
regimes. It shows you how violently the stock
17:35
behaved during previous market downturns compared
17:38
to its peers. It shows you the liquidity. I mean,
17:41
are people actually trading this thing or are
17:43
there massive gaps in the volume? That is purely
17:46
descriptive, but that description is deeply valuable
17:49
for understanding the temperament of what you
17:51
are actually holding. Now we need to add a caveat
17:54
here. If your entire strategy is just buying
17:57
broad index funds every single month for 20 years
18:00
in a retirement account, you don't need to draw
18:03
trend lines. No. Definitely not. You don't need
18:05
to look for moving average crossovers on your
18:07
S &P 500 ETF. For a long term, purely passive
18:11
investor, the daily noise of support and resistance
18:13
is entirely irrelevant. But understanding these
18:16
concepts helps you decipher the market's broader
18:18
behavior. When the financial news is screaming
18:20
about a death cross or a breakdown below major
18:23
support, you will understand that they're describing
18:26
human psychology and trailing price action, not
18:29
necessarily a prophecy of the future. So we started
18:32
by comparing technical analysis to looking at
18:34
the line outside the restaurant instead of examining
18:37
the ingredients in the kitchen. We've explored
18:40
how fear memory and regret literally paint invisible
18:45
floors and ceilings on a chart. The psychology
18:47
of the crowd. We unpacked why momentum structurally
18:50
exists and why academics warn that beautiful
18:53
backtests usually fail in the real world. Ultimately,
18:57
while technical analysis may not provide a crystal
18:59
ball, it forces you to implement the ultimate
19:02
investor survival tool, deciding exactly when
19:05
you are wrong before the market makes that decision
19:07
for you. It reminds us that markets are not perfectly
19:10
rational calculating machines. They are made
19:12
of people. And people have memories, regrets,
19:14
and fears which dictate how they behave. But,
19:17
you know, this raises a fascinating dilemma that
19:19
builds on everything we've discussed today. Oh,
19:21
what's that? Well, we established that chart
19:23
patterns exist largely because human psychology
19:25
repeats itself. But as algorithmic and quantitative
19:28
strategies increasingly dominate daily trading
19:31
volume, we are rapidly moving into a market run
19:33
by machines without emotions. Right. Machines
19:36
don't care if they're down 25%. Exactly. Machines
19:39
don't feel regret when a stock drops. They don't
19:42
feel relief at breaking even. So the question
19:45
we have to ask is, will these historic chart
19:48
patterns simply vanish as human psychology is
19:52
completely removed from the tape? Or will the
19:54
algorithms ironically learn to artificially mimic
19:57
human fear just to exploit the few of us who
20:00
are left? It's a crazy thought. We'll leave you
20:02
to think about that. Thanks for joining us on
20:04
this Deep Dive.