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.
Good point, the widget efficiently demonstrates the limitation of the technical analysis: it works only in retrospective. Just like a naive gambler at the roulette table, who thinks that after a series of red numbers, the chance of a black one is increasing. The truth is the chances are fixed (48.64 % or 47.36 $ depends on the type of the roulette).
ReplyDeleteBut unlike the roulette table, in which the naive assumptions of the players don't affect the results, on the stock market they do. The investors all looks at the same graph, and react to it. Technical analysis is a prophecy that may fulfill itself.
FlyHi, I agree that techncal charts may in theory affect traders who may react to this information based on assumptions about how other traders will react. But note, this has nothing to do with technical analysis, but actually an example of the opposite approach to trading - the fundumental analysis. Fundumental analysis approach is based on the actual facts of the company, market, currency or commodity. The technical charts in that sense, are just another piece of information the fundumentalist should consider.
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ReplyDeleteas i see it you are just one of those guys who heared, seen, "know" or whatever about technical analysis, but it is clear you know nothing about it.
ReplyDeletei call it my technical decision model i use some common tools all available anywhere...
the real "trick" is not when to get in or out. its what to do if you were wrong or you were right, that's the secret, and that's a mental talent/challenge, all in your head.
i'm a small as you call us: "technical analysis gambler" i only make $1m a year a modest clean profit thats all.
I can't see how the random chart contradicts the technical theory. Just look at the chart and you'll see that as long as the price line was above the Moving Average, the prices went up, and the opposite. Works like a charm in 15 charts i've tried.
ReplyDeleteMichael's comment really proves my case in four lines better than the whole post. If the MA chart seems to indicate entry and exit points on the random chart, the only logical conclusion is that the MA indicator only fools our eyes
ReplyDeleteHow's that? if you bought and sold at every cross of the price and the MA, in the long run, you were very successful. and if it works in a random chart, so it will work even better in a "rational" (as you claim) market.(although the fundumentals news almost always trail the real events in the stock\market)
ReplyDeleteGidi, think about it seriously: the numbers are RANDOM, so by definition you cannot predict them. When you look at the MA, and think it shows you good entry and exit points, this is only an illusion. A trick of the eye. To put it in other words, if you think MA can help you predict random numbers, go to the roulette table and get rich
ReplyDeletenot to predict... but to give a tool to FOLLOW the price as close as possible in the desired direction.In my opinion, a common mistake about technical theory that people think it tries to predict the trend, when actually it allows to FOLLOW the trend + using statistics, give a probable point for the trendt to end\begin. it is just a tool to help simplify the price changes, nothing more.
ReplyDeletein other words, try to identify the probable direction and try to verify it with indicators (MA for example)
ReplyDeleteGidi, "probable direction", "following" the price, etc. are just the same. If you believe that MA can give you any type of guidance with respect to purely random numbers, I'm afraid I will not be able to convince you in anything
ReplyDeleteI respect your opinion. I guess only time will tell who's right. Meanwhile, my method is working very well for me.different strokes for different folks
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