There is a large section of those who trade the stock markets who subscribe to a trading approach called market technical analysis. This is especially true of the retail segment of traders, tempted to trade online by the technology-driven opening up of the market. The barriers to small scale trading have been shattered by the ease of access on a broadband internet, software innovation, and aggressive marketing by stock brokers.

But what is market technical analysis? And what risk does it hold for the individual retail trader in the stock market?

Pure chart play

Market technical analysis is a technique of analyzing the pure patterns of a market, independent of the fundamental factors - such as the Fed interest rate or leading economic indicators - that are usually seen as driving the price of a stock. A typical fundamental view is that rational investors are seeking to maximize returns from their investments, and price moves are related to the imperfect supply of information on the earning potential of a stock. When there is a new piece of information on the future income of a stock, for example, when the global financial crisis first hit, the stock will be mispriced. There will be a sell off to a level that the market sees as the new correct pricing, based on the revised information on dividends.

It’s not that the technical analyst doesn’t see that news event driving demand for stock - they just don’t use this information as their primary driver in deciding where to put trades on, and when to close them out. They could care less if several top no load mutual funds drop a particular stock from their holdings. They see the market being represented completely in charts and conforming to certain patterns, which are repeated, and are therefore predictable. Charts are used, onto which statistical indicators are placed, that aid the decision as to whether a predictable cycle has started, or ended.

Can the charts bite back?

For the retail stock investor, especially one just learning to invest money, market technical analysis can be financially dangerous, as it encourages a faith in the ability to trade successfully, without a thorough understanding of the economics of each stock. The professional technical analyst will always use the fundamentals of the stock to set the context in which they trade. The retail investor is encouraged to trade robotically, according to simplistic rules, and is thereby likely to sustain big losses that could otherwise be avoided.

Also, because the simpler rules of market technical analysis are themselves predictable, where there is a large number of traders following the same strategy based on those rules, there exists the potential for counter technical plays. Large funds can use their market shifting potential to trip up the typical technical entry and exit points, and thus turn the table on the more simplistic technical traders. It is the retail player in the stock market today who is most likely to be burned by such activity.