Why Technical Analysis?

The issue of technical analysis (TA) and its relevance to trading and investing has come up numerous times here. Is it valid? Is it just “backward looking” mumbo jumbo that’s no more useful than throwing darts? I’m not writing here to change anyone’s mind on the subject. I’m simply going to explain why and how technical analysis is in employed across a broad community of traders and investors. The rest is up to you.

This discussion will begin with a hypothetical question? If a trader using TA makes 10 trades and is wrong 9 out of 10 times, is he a loser? Is his technical analysis bad? The quick answer is to say: “What a shit system that is. TA is crap after all!” However, what if the trader only lost 1% of his Trading Capital on every losing trade, and made 15% on his one winner? Should he still be considered a loser? Of course not, because he actually earned positive returns across 10 discreet trades. While this may seem like an extreme illustration, it’s not far from the truth for successful traders using technical analysis.

In general, a technically based trader WILL have more losing trades than winning trades. The key is that his winning trades will be large while the losers are small. At least they will be if he intends to keep eating!

This is one of several reasons why academic studies on technical analysis, and its validity, miss the point. The other major reason why some of these studies “lose the plot” is that they focus only on “trend following” moving average systems. The reason they do this is because it’s actually the ONLY “technical system” they can study with the data and computer power out their disposal. Put plainly, it’s EASY to backtest a moving average “system,” which is one of the reasons that “moving averages” are some of the least useful systems out there!

Forecasting vs. Trading for Profits

The primary technical approach we use is “Wave Theory.” It’s based on the idea that market patterns develop in certain specific ways and obey certain rules/parameters. Because of this idea, Wave Technicians, or Ellioticians, are capable of coming up with “forecasts” for future price action. In fact, beginners LOVE coming up with such forecasts as it feels “empowering” to believe that one ‘knows the future.’

However, there is a HUGE difference between developing a “forecast” and trading for profits using Wave Theory--most Wavers don’t know or understand this key difference. There is a tendency to become “wedded” to a forecast which often leads to losses and disgust with “the Theory.” After all, what good is Wave Analysis if one can’t get a useful forecast to trade with? In the eyes of many, the “Theory” becomes a bunch of hocus-pocus backward-looking bullshit that is good for nothing. The problem for most is that they assume one needs a perfect forecast to make money, when if fact, nothing is further from the truth.

Glenn Neely frequently uses the following the analogy to make the point:

If you were put near a river in the middle of some foreign land and were asked to point to the direction of the Ocean, could you do it? The reality is you couldn’t do it with any amount certainty because it’s difficult to know which direction that river is really flowing. It could be flowing east as far as you can see, but the Ocean may actually be to the South of you. But, does it really matter?

That’s the “heart of the problem” for many Wavers: the desire to use their well-studied forecasts to come up with “the” specific direction the river will take them on the way to the Ocean (trading profits.) The "Truth" is that it just doesn’t matter. All one needs to do is jump in the boat and start going “with the flow” of the water, as it will inevitably lead to the Ocean. The main goal should be to avoid the rocks and navigate those sharp turns along the way. That is my primary use for wave theory: It helps me to avoid turbulence on the way to the Ocean (trading profits.)

One can come up with all sorts of beautiful charts and forecasts for the next several years, but it’s all pretty useless in terms of making profits. The key is using Wave Theory to set up positive “risk/reward” trading scenarios and to help know when one is either flowing with the stronger currents, or getting tossed around in the rocks.

This is why, along with a market “forecast,” I also identify critical support and resistance points in my reports. Please keep in mind that the latter is usually more important than the former.

Good Luck,

Andy T.

10 comments:

CV said...

Thanks for that primer AT...

Nic said...

Good point well made.

McFearless said...

Nice post Andy, the part about performance is the one that most people on the web should pay close attention to. I continue to see people say things like "TA is wrong half the time", maybe it is, maybe it's wrong more than that in some cases, yet that statement still doesn't tell you anything about gains or losses using TA.....I always use the baseball player example...All-Stars in Baseball often bat in the .300's., it's been how many decades and nobody has been able to beat Ted Williams' .400 BA? My other favorite is that TA is always biased, to which a technician only need to respond: "compared to what type of analysis", name a pundit that does fundamental analysis that isn't biased....name just one. Bias is always and everywhere, regardless of method.

Some of the best known traders of all time are said to only get 30% of their trades right. The two primary issues with trading no matter what set of tools you use are cutting losers fast enough and knowing how to take big gains when they come along, the latter is in fact a hell of a lot harder than the former.

People seem to put a ton of faith into Mark Hulberts newsletter tracking as well as the coax site or whatever it is that does the "guru" tracker. I don't know about everyone's calls on there, but I know Hulburt, for example, never included in Prechter's performance his Nikkei short call in the 90's. Think that would have made any difference to the performance? There are several other calls that were not included in performance which Prechter has described to subscribers over the years, so I only wonder what is going with everyone else they track. Further, people seem to want to forget that past performance doesn't pertain to future results.

In the same way, and sorry to have to use him several times, but I follow them closest, the point you make about losses on losing trades is really important. Prechter has called the top of P2 several times in the last year, but look, he called for it last September, and we got a drop in the market, he called for it on the day of this years January top, and we got a drop, and he gave a range several weeks before the April top and again, a drop and this time the largest drop. Now one could have made a lot of money or broken-even on every single one of those trades despite the fact that outside of this last one, we do know it wasn't THE top.

Anyway, we could go on and on about this, or I could, but this was a good post, that's the point.

spoonman said...

Great post Andy. That is one of the reasons I love your updates - I know when they're wrong. On my own I just use simple TA(moving averages, support/resistance lines, etc.), but the key thing is that I know when I'm wrong. TA is less about predicting the future, and more about having a line in the sand to know when you're wrong. Of course, I'm an idiot sometimes, and hold on for too long, hoping for the market to come back to me. Emotions, you know. They'll get you every time...

McFearless said...

I'm actually more interested in this thread right now than I am in the other one. I'm not sure I've ever shared, and maybe nobody cares, but this is some of the simple background as to why I got into TA and use TA as a primary tool rather than fundamental analysis. I came out of school learning nothing but fundamental analysis and I work in a position where technical analysis is generally frowned upon, so it took a lot of time for me to be convinced what I had been taught for so long had flaws. In fact, I eventually realized that the methods I was taught were so flawed that I could never use them effectively enough to extract anything from the markets, and this is the goal of everyone involved with markets.
For me I have adopted the following because it is the formula I tend to win with:
1. The Wave Principle as my primary tool and yes, I am open to Glen Neely's interpretations on waves, or anyone else that charts them for that matter. I do my best to apply the principle with discipline (don’t stretch rules or guidelines to fit your own count) and to do it with price and volume activity. Do I do this without bias 100% the time? Lol, of course not, I’m just like everyone else, I HAVE emotions.
2. Percent rate of change indicators at varying degree of trend from hours, to months and years, to help confirm my assignment of probability via my wave count and to confirm trend changes/areas where divergence will occur and I'll be wrong.
3. Sentiment indicators, I use several different services for this. Clearly from my comments I’m very much interested in sentiment in many various forms.
4. General fundamental analysis, primarily where I focus is the larger overview of money vs. credit, understanding how credit and money are created and where we are in that creation or destruction cycle and I branch from there. It took me many years of constant study to build just a half decent working knowledge of what the hell the dollar even is.
No single one of these should be treated as an absolute, it is never the levels that matter it is their relationships to recent behavior. I can't only win with Elliott wave as my one tool, iow. My primary goal with my method is to try and identify larger wave structure points where the theory indicates that a change is imminent. For me, I’ve found the wave principle to be the best primary way to understand the framework of a market and where prices are within that framework. Recently I’ve begun to work harder on more detailed Fibonacci application, but this remains a work in progress with mixed results. I find this much more satisfying on a number of levels than reading rearview mirror fundamental data, which I may or may not be able to trust, and trying to extrapolate from that data the trend of future prices in markets. Instead, I choose a degree in the wave pattern appropriate for the trade I want to perform and I buy or sell based on the interpretation of the wave pattern. As I’ve mentioned on the site several times I tend to trade the larger patterns as I’m more of a position trader than a day or swing trader. If odds are very closely matched between a bullish and bearish outcome then I don’t do anything at all, I just wait, which is not hard to do once you practice it. As I’ve maintained, there are hundreds of systems that work good for trading, this brand of TA is just what works best for me.

McFearless said...

My interest in wave came about after years of interest in Fibonacci and Geometry when I was much younger and also after years of frustration with more traditional methods of market analysis. Anything that has a growth and decay pattern will find the golden ratio within it, like Ra’s hurricane, our own bodies, galaxies, or a simple Sunflower. The shape of the golden ratio is the spiral, while reading about the golden ratio many years ago I stumbled upon EWI by chance and I’ve been an avid student ever since. I saw all the same objections as everyone else very early on with waves, mainly that people think anyone that practices it is some sort of mystic. This is not true, a mystic believes in things for which there is no evidence, only desire. I don’t consider myself a mystic at all, I doubt Andy does either. While any wave analyst can be subject to their own bias, and EWI is certainly guilty, the Elliott Wave Theory as a stand alone is an entirely objective approach. Many people call it subjective because they focus on the analysts calls rather than the theory itself. The Theory is always at work, I just interpret it incorrectly from time to time, this is not a magic box that tells you all the right answers. That said, even if it were subjective, again, name one type of analysis that is not, fundamental analysis is almost entirely subjective because people are using old data, not real time market data, to make forecast about future trends. My own observation is that more often than not the only people that interpret fundamentals properly are the technical analysts. The true mystics are the economic professors at most universities or those that sit on the Fed, the people that believe current economic performance can be used to predict stock market prices.
In 1986 the Elliott Wave Theorist put out 6 rules ‘what every trader needs to be successful’, and I’ve tried my best to follow these rules with my TA method above. Here they are:
#1: A method: Any time you enter or exit a market, it must be for a predetermined reason that will also apply in the future.
#2: Discipline: to follow the method. Without discipline, you really have no method in the first place.
#3: Experience. The School of Hard Knocks is the only school that will teach you the emotional aspects of investing, and the tuition is expensive.
#4: Acceptance of responsibility: Don’t blame the news, insiders, floor traders, or THEM for your losses. Accept responsibility, and you will retain control of your ultimate success to the extend that the market allows.
#5: Accomodation of losses: the perfect trading system does not exist, so your method must deal with taking losses.
#6: Acceptance of huge gains: When the big winner finally comes along, you need the self-esteem and confidence in your method that it promises.
I could talk for a very long time about the why of TA, or go over trades I’ve made in the past or just this year using my method, but for now I just want to end with a response to a question from RP. Many people believe that TA is “self fulfilling” or deterministic, and they also think that people at EWI claim to “know the future”. None of these are true.
Question: Will the Wave Principle win out over those people (people that reject is who they are referring to) and become an accepted part of financial science?
Answer: Yes, because it’s true. It has already won out over obscurity in finance. The new science of chaos will prime even more people to give it the time of day. And we shouldn’t forget the incentive to do so. After all, the Wave Principle may be nature’s way of giving us a peek at the future. Of course, that is only a peek, not the full panorama. Foretelling the future with exactitude all the time is not one of the blessings available to man, and likely never will be. But what an advantage some of us now have over everyone else in that endeavor! As in so many fields, all it takes is an edge over the competition, and you win the game.

Andy T said...

Thanks for the feedback Ben. I appreciate it.

McFearless said...

little typo on #6:

When the big winner finally comes along, you need the self-esteem and confidence in your method to take all that it promises.

McFearless said...

AT,

no problem, I enjoy this subject, it's one I've debated with myself many times over the years. the TA studies are often flawed for many reasons, one other example is that they can never identify how each trader would weight trades based on their confidence in a certain outcome, (higher probability pattern vs. a less clear chart)

if i was counting a nested 1-2 I certainly would never weight that trade the same as if I can count a solid five up or down sequence, though this is an extreme example, it makes the point.

Andy T said...

McFear@2.54.

Exactly!

There are moments of extreme confidence and moments of "lukewarm" confidence at best. Each might merit a 'trade' of some kind, but certainly with a different weighting.

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