On of my favorite trading groups I belong to on LinkedIn is all about traders’ psychology. The group leader posed a multi-part question concerning the uses and value of Technical Analysis (TA). Having traded with TA for nearly 30 years, and mentored other traders with TA for nearly 14 years, I have some strong opinions about TA. What follows are my reply postings.
WHY USE TECHNICAL ANALYSIS?
This multi-part topic can spawn discussion ‘till the proverbial cows come home. In 2014 I will have been trading with TA for 30 years and mentoring other traders in TA for 14 years. In that time, I have formed opinions about all the sub-topics listed. I will try to capsulate them in the hope of adding value to this worthy string.
IS IT ALL JUST AN ILLUSION?
Yes, to the same extent all reality is an illusion. Quantum physics tells us that at the subatomic level matter is immaterial waves of energy until a sentient observer causes it to “solidify” into particles. This leads to. . .
IS IT SELF-FULLFILING?
This question has aspects of one recently discussed on Morgan Freeman’s “Through the Wormhole” — Do We Have Free Will? Consider Fibonacci numbers and ratios. We know they exist in Nature from the spirals on a snail’s shell to the arms of a spiral galaxy. So, when a market retraces a perfect 61.8% is it because a host of traders believe that it should, or was it programmed to do so at the dawn of creation? Bottom line: it doesn’t matter to me as long as it works.
HOW CAN WE USE TA EFFECTIVELY IN OUR TRADING?
Einsteinian Relativity says that if you have an object in a big field of empty space with nothing else around it for comparison, how can you tell if it is moving? Or, in what direction? Or, if it is accelerating or decelerating? So, one function of technical indicators is to provide a POINT OF REFERENCE against which to compare price movement.
Observation proves the inherent nature of price movement is constant up/down oscillation on all time frames. So, while the price contains all the data needed to predict where it will go next, the important needle of information is buried under a haystack of irrelevant static and noise. So, the second important use of technical indicators is to FILTER out the unhelpful zigs and zags.
Consider the humble moving average. It is a perfect example of both POINT OF REFERENCE and FILTER.
On a less-theoretical, more-practical level, TA helps us confirm tops and bottoms. In day trading, in particular, we seek to profit by capturing relatively small moves. Thus, traders who can make aggressive entries tend to fair better than those who feel they must wait until the very last duck is in a row before pulling the trigger.
I tell my students that a market starts to go up as soon as it stops going down and vice-versa. In my last webinar I listed some of the tools available to find those critical turning points: Parabolic SAR, Donchian Channel, Pivot Points, Elliott Wave counts, 1-2-3 tops & bottoms (aka Failure Swings), Fibonacci retracements and extensions, oscillator divergence and crossovers with rising volume.
FUNDAMENTAL OR TECHNICAL: WHICH IS SUPERIOR?
I believe technical is superior without question. Here is why. Fundamentals TELL us what the market SHOULD be doing. Technicals SHOW us what the market actually IS doing.
Much fundamental data is second, or even third-hand, significantly attenuated from its original source, and is proffered by pundits with “no skin in the game.” Technical analysis is based on the actual movement of the price brought about by real traders who believe strongly enough in their predicted outcome that they have “put their money where their mouth is.”
I tell my students that I classify myself as 95% a technical trader. When fundamental info about a market I’m following crosses my path, I will give it my attention. To do otherwise would be foolish and arrogant. But, I do not seek out fundamentals, because, in truth, I do not need them.
I subscribe wholeheartedly to the two-part credo of the technical analyst:
1) Whatever is known about the market, from any source, is already being reflected in how the market is moving, and
2) History repeats itself. If we see a certain pattern or signal and thereafter the market rallies, it stands to reason that the next time we see that same pattern or signal, there is a reasonable probability that the market will rally again.
TECHNICAL ANALYSIS: ART OR SCIENCE?
Clearly, a bit of both. In my humble opinion, good technical traders possess knowledge, temperament and experience. The artistry comes in how these three elements are combined.
While there are many computerized trading systems that can perform successfully in a narrow range of market conditions, I believe that a good discretionary trader will always prevail over a simple mathematical model.
Knowledge refers to the construction and performance of technical indicators. This can definitely be programmed into a computer.
Temperament refers to how aggressive or conservative the trader is and is related to their motivational bias. Do they move toward pleasure and reward or away from pain and punishment? As uniquely human as this sounds, this too can be programmed into a computer.
Accumulating experience, learning from that experience and knowing when to amp up temperament to allow experience to trump knowledge – these are the biggest challenges trading programmers face.
At the moment, that “good discretionary trader” would have to be a human being. But, the time will come when artificial intelligence has progressed to the point where we mortals no longer have the advantage. Still, I believe art is art whether it is created by neurons or electrons.
DOES A TRADER NEED TA, OR IS “TAPE-READING” JUST AS EFFECTIVE?
My definition of Technical Analysis includes price itself, price patterns, signals from indicators like moving averages and oscillators, and signals from various drawing tools like trend lines, regression channels and Fibonacci retracement and extension grids. My TA definition definitely does NOT include the alpha-numerical data of the traditional ticker tape.
In Edwin Lefevre’s classic, “Reminiscences of a Stock Operator,” the author describes his tape-reading successes in the “bucket shops” of the pre-crash, pre-Depression, pre-SEC stock market. Perhaps there are still folks around today who can match Edwin’s skill with the ticker, but I don’t know any. All my trading friends use some level of TA.
My good friend, Ken Chow, fellow mentor at Pacific Trading Academy and author of his proprietary “SuperStructure” trading method, is a real TA minimalist. He uses a couple Fibonacci tools applied to otherwise bare-bones bar charts. He and his students are very successful, but his technique is a bit too sparse for me. My trading mentality is more dependent on visual input. I love my red, white & blue color-coded indicators and would not like to give them up.
It seems to me that good tape-readers must have a strong internal frame of reference – the kind of people who can play a game of chess completely in their heads. My version of TA seems much easier.
WHY DO SO MANY GOOD ANALYSTS MAKE BAD TRADERS?
When I mentor other traders, I spend a significant amount of time getting to know my students to determine where they fall on the spectrum of traders’ personality types. The people I have known who fit the “good analyst/bad trader” mold have had a few key traits in common.
They tend to have jobs that involve a demanding level of precision and/or an extensive amount of pre-planning prior to execution. For example, accountants, surgeons, programmers and various types of engineers. Their worlds are more black and white. They have trouble with gray.
They also tend to be moderate politically, frugal financially and reserved socially. Their NLP motivational bias is more likely to be moving away from pain and punishment as opposed to moving toward pleasure and reward. As a result, in the trading arena their primary goal is never to win, but rather to not lose.
Have you ever dabbled in affirmations? They are those simple positive statements that you repeat on the treadmill or stationary bike that are designed to improve your health, finances, romance, etc. If so, you’ll recall the admonition to always make them in the affirmative. State what you want, not what you don’t want. If you focus on not losing, your subconscious mind only hears LOSING and broadcasts that request to the Universe.
If the quantum physicists are correct, and we are co-creators of physical reality through our purposeful intentions, there is all the more reason to believe in the power of positive thinking. The best traders I know enter the market filled with an expectancy of victory and they receive what they expect more often than not. This simple truth seems to elude the overly-analytical.
IS TA AS VALUABLE FOR INVESTORS AS FOR TRADERS?
Let us first define our terms. To me, there are INVESTORS, MECHANICAL TRADERS and DISCRETIONARY TRADERS.
An INVESTOR places his money with a third party who is in charge of managing the subject matter of the investment. The investor hopes that the third party will manage the investment with sufficient expertise to generate a profit in which the investor may share. Whether or not TA is valuable to an INVESTOR depends on the nature of the investment. If it involves the trading of some financial instrument, then the answer is yes.
A MECHANICAL TRADER utilizes a computerized trading system, or the recommendations of an advisory service. A MECHANICAL TRADER that licenses a trading system from a system developer and also pays a broker to execute the trades generated by the system is more of an investor than a trader. A MECHANICAL TRADER who uses an advisory service is an INVESTOR/TRADER HYBRID. The third-party advisor selects the trades and the MECHANICAL TRADER simply executes the advisor’s recommendations in non-discretionary, ministerial fashion. If the advisor uses TA to select the recommended trades then it is valuable to the MECHANICAL TRADER. If the advisor does not use TA, its absence will be a detriment.
A DISCRETIONARY TRADER exercises personal choice and control over the instruments traded, and the time and manner of entries and exits. To me, the only true trader is the DISCRETIONARY TRADER. Technical analysis is always valuable to the DISCRETIONARY TRADER.
That’s all I have on this multi-part topic. If you have followed me this far, thanks for your kind attention.
