If you search the Web for an investment strategy to improve your trading results, you will soon be advised that "the trend is your friend". This seems to be a good start, for all you need is identify the trend and you are all set. This insight, roughly speaking, is 50% of Technical Analysis theory which aims to be capable of nothing less than predicting the future prices of securities, currency, commodities and whatever.
The rest of Technical Analysis theory is all about price patterns. Technicians search for archetypal patterns, such as the head and shoulders or double top reversal patterns, study indicators such as moving averages, and look for forms such as lines of support, resistance, channels, and more obscure formations such as flags, pennants or balance days [see Technical Analysis @ Wikipedia]. And why should we assume that price patterns are expected to re-occur in the future? because, we are told, history tends to repeat itself.
So how do technicians identify trends and price patterns? well, they use charts. Lots of them. Colorful, eye-catching charts. This is why Technical Analysis is also called charting.
Criticism of technical analysis theory is very wide. I'm bringing no news here when I claim that Technical Analysis fails to prove its case, that is to predict future prices. Indeed, the very basic assumptions of Technical Analysis are dubious, to say the least. Is the trend really a friend? which trend are we talking about here? of this hour? day? week? month? year? At any time circle, price movement is at some point reversed. How can we tell if this is the end of the trend or only a short break before the trend continues? A more truthful statement would probably be "the trend is your friend (until it isn't)". The same goes for the other core-assumption of Technical Analysis: "History tends to repeat itself (but sometimes it isn't)".
My claim is that Technical Analysis is basically a bluff based on a trick of the eye, like a cheap magic performed by the neighborhood clown in a children birthday party, hiding the pigeon in his pants. This statement deserves some elaboration I guess, so here it is.
I must admit: when I look at the colorful technical charts I'm usually convinced. The lines seem to clearly indicate what could be good entry and exit points. Take the very basic indicator - the simple Moving Average ("MA") - as an example. Whenever the price line crosses above the MA line I should go long, and close the position when the price line crosses below. How simple! Let's get rich!
However, as always the case with moi, doubts are crawling and knocking on my head. With all these colorfull charts everything seems to be too simple. Can it be the case that my eyes are fooling me? That what seems to be buying & selling triggers on the charts are actually more a result of random movements than of patterns & trends? I decided to check this out, by making a small experiment. Let's try to run these nice charts on random numbers rather on real prices and see how the technical indicators would look like. My experiment is available for the reader review in a form of small widget that generates random-based price line (in blue) with a simple 7-day MA indicator on top of it (in red). Play with it, but beware! if you have an itch to put your money on my random stock remember - it's just a Bluff...
As a reference to our random chart, let's start with some real charts. Click the well-known symbols below to load their charts.
MSFT
GOOG
AAPL
YHOO
Now, let's turn to our random chart. Click to Reload the radnom chart.
