Is technical analysis a fallacy, do we see what we want to see?

Jan 16 • Between the lines • 2939 Views • Comments Off on Is technical analysis a fallacy, do we see what we want to see?

In the early stages of our career and relationship with trading we endure many baptisms of fire. One of the most exciting ‘trials of trader life’ we endure is shortly after we discover technical analysis.

For many of us our discovery of technical analysis begins with someone, either in person, in a trader school environment, or on the internet in one of many trading forums, introducing us to something quite basic. For some of us it could be something as simple as a moving average. For this author it was actually the 21 day simple moving average, plotted on a 4 hour time frame that sparked my curiosity beginning a near decade ‘love-hate’ relationship with indicators and technical analysis. Price crossing to the downside and closing down sell, to the upside buy. Actually, on reflection, it’s close to being one of the three components of using Bollinger Bands in a trading strategy, so perhaps it’s not as amateur as it seemed.

Stage one; we discover technical analysis

The creativity technical analysis sparks in our grey matter, once we’ve initially found it, is considerable, it’s mind blowing. Suddenly we have all the answers to many of the problems the market has presented. We believe that all of our market ‘puzzles’ can now be solved through; indicators, moving averages and other technical analysis methods. We’ve cracked it, now all we have to do is find indicators that actually work and this time next year we’ll be taking our trades whilst on a Sunseeker Manhattan cruising in the Bahamas…if only…

Stage two of our relationship with indicators

Once we’ve discovered technical analysis and in particular indicators, we enter into the second stage of our relationship with technical analysis; trying to find an indicator, or a cluster of indicators that will actually work, in as much as they’ll actively encourage us to make the right decisions regarding; which trades to take, when to enter and when to exit. We may at this stage also begin to experiment with back testing which, given that it may curve fit our trading method, will more than likely deliver the positive results we crave.

Now this second stage of experimentation with technical analysis can eat up a long time, years in the majority of cases. We’ll happily dedicate months of our time investigating the particular benefits and characteristics of certain indicators and the combinations that may exist. And then the germ begins to develop in our grey matter, a germ of an idea that we at first attempt to repel and bury, but eventfully we begin to face up to it and we ask ourself the inevitable question after months, or years of searching;

What if technical analysis is hocus-pocus, mumbo-jumbo? What if it’s just a fallacy and I’ve been wasting my time for years?

Stage three; we realise just what technical analysis can deliver and what it can’t

We’ve now entered the third phase of our relationship with technical analysis, it’s only now that we elevate our thinking to begin to really understand what technical analysis does and more importantly what it can’t do. This third realisation step means that we’re actually very close to becoming successful traders – we’re beginning to ‘see through’ indicators and we start on the final leg of our journey to what we often term as “trader enlightenment”.

One of the first and arguably the most important conflicts we resolve, with regards to our relationship with indicators and technical analysis, is waking up to the fact that (despite rumours to the contrary) all indicators and technical analysis lags, they never lead. If they did have some fabled astrological powers you can be sure some Wall St hot shot quant would have devised a trading method to take just enough of all of the money in the market to leave enough left to create a thin market left for us flailing fools.

There is no indicator or trading method using techs that can predict, with any degree of certainty, what price will do next. What we can do is use our lagging indicators and technical analysis, combined with historical chart evidence, to make a really good call as to what price ‘might’ do next. Added to that we can then begin to observe the fundamental analysis on a day to day basis and check how price on the day is reacting to the various pivot point levels each day. We can then combine it with the price action we can see on, for example, the single daily candles.

In stage three of our relationship with technical analysis and indicators we realise that tech analysis simply highlights milestones on a road. We’re not underestimating indicators or technical analysis, or dismissing it, we’re using techs in the correct manner in the full knowledge that they’re not a mathematical solution to unlock untold rivers of money to pour in our direction, they’re incredibly powerful mathematical tools that can help us determine probably what the market may do next.