Technical Analysis Fact and Fiction

November 12, 2012
By
Vault
 

“Technical analysis, I think, has a great deal that is right and a great deal that is mumbo jumbo…

“There is a great deal of hype attached to technical analysis by some technicians who claim that it predicts the future. Technical analysis tracks the past; it does not predict the future. You have to use your own intelligence to draw conclusions about what the past activity of some traders may say about the future activity of other traders.

“For me, technical analysis is like a thermometer. Fundamentalists who say they are not going to pay any attention to the charts are like a doctor who says he’s not going to take a patient’s temperature. But, of course, that would be sheer folly. If you are a responsible participant in the market, you always want to know where the market is — whether it is hot and excitable, or cold and stagnant. You want to know everything you can about the market to give you an edge.

“Technical analysis reflects the vote of the entire marketplace and, therefore, does pick up unusual behaviors. By definition, anything that creates a new chart pattern is something unusual. It is very important for me to study the details of price action to see if I can observe something about how everybody is voting. Studying the charts is absolutely crucial and alerts me to existing disequilibria and potential changes.”

- Bruce Kovner, Market Wizards

JS comment:

Bruce Kovner pulled billions out of the markets, over multiple decades, before handing the reins of his fund, Caxton Associates, to the next generation of traders.

As an academic in a past life, Kovner was known for his deep dive fundamental analysis — but he also used charts extensively, as the Market Wizards excerpt shows.

Those who dismiss technical analysis as useless are like those who say martial arts is useless in a fight. Perhaps they took a few classes, got their butts kicked at the brown belt level, and gave up… thus assuming the discipline has no value to anyone, even though this assumption is laughable. (As Bobby Deniro said in Heat, “When you assume, you make an ass out of you.” Period.)

Non-practitioner academics, on the other hand, tend to dismiss the value of technical analysis without any real market experience at all, on the basis of straw man research studies so obtuse they are more comedy than science.

Consider, for example, the academic study (of which a variety have been conducted) that says “XYZ pattern is useless” because, according to X parameters tested over 5,000 instances of the pattern across a sample case of 500 stocks, the net result was unprofitable.

The problem with studies like this — and they all run into the same gross overgeneralization issue — has to do with the irreproducible elements of experience, situation and context.

For an academic study to say “X pattern over X thousand instances failed to work because we couldn’t make it work” is similar to an armada of geeky lab-coated researchers testing a pick-up line by repeating it verbatim, in monotone, to thousands of women in hundreds of bars.

Would their findings have any merit as to whether the line “works” or not? Of course not. Success depends on 1) who is delivering the line, 2) how it is delivered (the skill quotient involved), and 3) the spots in which they choose to do it (discernment and situational context).

It is the same with various patterns and technical inputs, because all too often a pattern is not useful in a vacuum, but has value as an input along with a confluence of other supporting factors. It takes a trained eye to know when to pull a trigger versus when not to — a qualifier that is obvious in so many other expert-level fields, it is surprising the degree to which it is overlooked here.

Last but not least, the credibility of TA is assaulted by those ‘true believers’ who claim charts, with the help of some magic juice, have guaranteed predictive power in foretelling a future event or result… but of course this is silly. On deeper examination, the assertion does not make any logical sense. Why would lines on a chart predict the future with guaranteed certainty, any more than goat entrails or chicken bones do? Where is the rational explanation for such belief?

What one can say and explain rationally, and demonstrate successfully, is that certain patterns, in certain situations, have enough probability of producing a desired result as to make a trading wager profitable on a repeated trial basis.

If, say, pattern Q against a backdrop of supporting factors X, Y and Z produces a profitable result 50 to 60% of the time — or if the embedded risk / reward has an attractive enough multiple even with a less than 50% follow-through — then the pattern has potential to be exploited profitably by the sufficiently skilled and experienced trader, who often uses a combination of fundamentals and technicals, along with good judgment, in a manner that no ham-fisted academic study can replicate.

It ain’t rocket science or voodoo. But it does require a discerning eye…

JS (jack@mercenarytrader.com)

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5 Responses to Technical Analysis Fact and Fiction

  1. Dick on November 13, 2012 at 7:37 pm

    The only sure things in the market are price paid and volume, the rest is speculation. Technical analysis is vital to interpret these two sets of data.

    • Simon T on December 3, 2012 at 10:41 am

      You just summarized it all. Well said!

  2. Brick By Brick Investing | Marvin on November 14, 2012 at 7:05 am

    Technical analysis is vital in how I trade stocks. I use technical analysis to find potential setups and fundamental analysis to validate that trade.

  3. Hugo on November 16, 2012 at 12:11 pm

    Excellent piece. And I couldn’t agree more with the opening line. What are your views on this guy:

    http://www.businessweek.com/news/2012-11-12/demark-fibonacci-charts-embraced-by-cohen-lure-investors

    I would have thought DeMark would be a “mumbo jumbo” fringe element (Fibonacci?) and yet he’s evidently being paid in the millions by people you’d think would know better. This guy is apparently outright predicting, including exit points well in advance. Do you think he’s a savant of sorts, or are his bad calls merely forgotten?

    • Jack Sparrow on November 16, 2012 at 5:50 pm

      Very interesting article, thanks for that.

      Without trying to disrespect DeMark, the piece speaks for itself:

      - An opening mention of Bentleys in the driveway
      - Later confirmation the millions are garnered through consulting fees
      - Blatant cherry picking of examples
      - Instances of the ridiculous (predicting Romney’s debate performance???)
      - Multiple references to “the language of God” (??)
      - Multiple references to “we don’ t know why it works”
      - Multiple instances of strawman attack on logical TA

      Re, whether DeMark is a savant, it’s quite possible his systems add value at the margins via the discovery of exploitable patterns that do tend to repeat with some sort of viable regularity, for reasons that are hard to articulate. This is not the same as giving credence to fibonacci etc, however, but rather an acknowledgement that the brute force of countless blind iterations can sometimes yield useful behaviors (this is how evolution works). If data mining hits on a productive result, the researcher can give credit to Fibonacci or Vishnu or Homer J. Simpson – that doesn’t mean the cause/effect match up is valid.

      As for why large hedge funds swear by the systems, my pet hunch would be something along the lines of a conviction placebo effect. I would hypothesize winning traders who swear by such indicators tend to ignore the signals that do not align with their own conviction, and use the added confidence when conviction does align to increase the size of their bets (or find the courage to pull the trigger in the first place).

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