Flawed Technical Analysis And Other Fallacies
Over the past few days I have seen very productive discourse covering a wide range of trading related topics. As humble host of this digital sanctuary one in particular has become a recurring theme for me personally as not a day goes by when I don’t encounter some hare brained train-wreck of a chart posing as ‘technical analysis’. As this is a veritable Pandora’s box of filled with confusion, assumptions, misinformation and deeply ingrained superstitions I will merely attempt to establish a number of basic tenets which should be appreciated as indisputable truths and serve as a quick acid test when evaluating any technical tools into your trading activities:
- Candlestick Charts are at best a rough representation of time series propagation. As such they are deceptive and can lead to misinterpretations of what happened in the past. One needs to be conscious of the fact that volatility as well as participation within one candle can vary widely. This spells true in particular for interval based candles which assign a series of price changes into time slots. Whereas an intra-day hourly candle may comprise over 10,000 ticks one recorded during off hours may sometimes only comprise 1000 ticks or less. This seriously calls into question the validity of interval based charts as market participation does not abide by the rhythm of a metronome.
- Indicators or oscillators which are a product of any time series by definition always have been and always will be lagging. Placing entries purely based on a time series based indicator or oscillator is tantamount to driving on the freeway whilst looking in the rear mirror. Oscillators may only represent a state within a range but rarely account for the explosive trending behavior propelling price outside of normal standard deviation thus producing ’embedded signals’.
- Mean Reversion is an illusion. Price is not naturally attracted to some artificial range or moving average. The one reason why price reverses after trending behavior is due to profit taking. During stop runs profit taking can occur without price reversion. The phenomenon we call ‘mean reversion’ is only observed when selling or buying is met by insufficient opposing demand, therefore driving price back in the opposite direction. As such concentrations of participation at various price ranges can have a large impact on price behavior. To expect price to always revert to a certain point due to ‘mean reversion’ is naive at best.
- Support and Resistance Lines are expected to represent inflection points observed by a critical number of market participants. There more touches the higher its visibility and thus the odds that a price range near a line is expected to accumulate buyers or sellers. However price is not intrinsically affected by lines on a chart but rather by the beliefs and actions of a large number of participants in a market. By drawing a line on a chart you are implicitly expecting other participants to anticipate and then observe the very same formation. Thus you are making a bet on consensus as well as the ability of others to perceive the same patterns and to observe similar price intervals on their charts (e.g. 5-minute, 60-minute, daily, weekly, monthly, etc.).
- Price Channels – see support and resistance lines.
- Retracement Levels such as fibonacci fans or pivot points are based on underlying formulas extracting support/resistance ranges based on prior price movement. Once again you are driving forward whilst looking in the back mirror plus the data analyzed is based on a particular time period, e.g. one day, one week, month, etc.. This should not be confused with statistical trading which is an advanced research topic among large financial institutions.
- Moving Averages only matter if they are being observed. It doesn’t matter if you follow a 20-day or a 100-day SMA. Similarly you could be following a 21-day or 101-day SMA – or a 25-day and 120-day SMA. At which point does your moving average lose its credibility/value? IF a particular moving average coincides with a number of turning/touch points in a particular time series then it is either due to consensus among market participants or pure chance. So instead of looking for a particular moving average to predict price movements instead seek one that best represents existing market behavior. The more touches the better – with recent touches most likely representing equilibrium separating buying/selling ranges.
- Chance and Random Events affect price movement. Sometimes an accumulation of random price movements over time produces context which is hence interpreted as a support or resistance zone and thus becomes one. Human beings constantly seek out patterns and will invent some if presented by purely random data. Appreciate the fact that random events may play a large part in how price movements are being interpreted by market participants.
- Buying/Selling ranges are separated by equilibrium zones which I often refer to as Inflection Points. All trading ranges are inherently a product of volatility (i.e. speed/velocity ratio) and participation (i.e. volume/pressure). Within inflection points entries are favorable as price tends to moves slowly until price follows the easiest direction in response to shifting market behavior. As such they could also be referred to as transition zones. Be aware that the odds of resolution shift constantly as time and price propagates. An support zone which is only tepidly being observed can quickly make way to a selling frenzy. In other words – a support zone only should only be considered as one as long as it offers support, the same applies to resistance zones. Some of the best long trades happen near resistance zones and some of the most lucrative short trades occur near support ranges.
- Volatility is comprised by price propagating at a particular speed and velocity. In a sideways market price moves at low velocity in comparison with the ongoing speed as represented by interval based candle ranges. In a trending market price moves at a higher velocity/speed ratio – meaning that we have high speed and a directional vector. Be aware that volatility differs significantly between period and tick charts. If price moves 3 handles within a one hour candle but most of those 3 handles happened in 500 ticks (within only a minute) then should the entire hour be labeled as volatile? The answer to that should be reflected in your trading system.
- Continuous Futures Contracts do not exist. They are helpful in establishing a larger picture but do not represent reality as you are looking at several futures contracts which have been merged to accommodate a larger time period. This complicates technical analysis in the futures markets for obvious reasons.
- There is no such thing as a Forex Market. Rather there exists a number of Forex islands which are all loosely connected. Prices as well as spreads can vary extensively as all forex traders are inherently prisoners of their particular forex island.
- Stocks And Its Underlying Companies are only loosely correlated. When you are buying a stock you are holding a derivative financial product which represents the collective opinion of the observants of the underlying company. Although senior management is always incentivized to increase the company’s stock prices it is important to realize that the two are in fact separate entities. There are great companies with undervalued stock prices and crappy companies with high flying stock prices.
- Assumed Risk has many faces and dimensions. For example futures and forex markets are commonly considered to be risky due to their inherent leverage. However I do not recall ever having witnessed a futures contract or even a currency dropping to zero (the latter usually go the other way when failing – thus admittedly affecting a cross). On the other hand the annals of the financial markets are littered with stocks that have done just that. Thus assumed risk should be clearly defined based on market, personal requirements/limitations, time frame, etc. Highlight various aspects of a market or instrument that may harm you and then prepare accordingly.
- What Everyone Knows Is Not Worth Knowing. It is rather surprising that such a thing as the financial media exist as any information available has exactly zero impact on your trading performance.
- Chaos And Uncertainty are the norm in all financial markets which stands in stark contrast with the expectation of most market participants who instinctively seek out order and predictability. Be cognizant of the fact that all financial markets operate on the notion of harming the largest number of participants.
- Zero Sum Game – In order for minority to produce significant gains a majority has to be on the losing side. Ponder on this irrefutable fact every single day.
- Hard Work is no guarantor of success. To quote Einstein: The definition of insanity is to keep doing the same thing over and over again expecting different results. Just because you read dozens of trading books and attended expensive seminars doesn’t mean you are a successful trader. In fact you are a only a successful consumer of trading literature and services.
- Successful Trading is an acquired skill as opposed to an inherent ability. Learning how to trade and manage one’s capital is more akin to learning how to play the piano as opposed to memorizing a book or a poem. The more you practice the better you get at it.
- A trader’s daily activities should be comprised of 40% risk control and 60% self control. In turn the risk control portion is only half money management and one half market analysis. Yet most traders emphasize market analysis while avoiding self control and de-emphasizing risk control. To become successful traders need to invert their priorities. — Van Tharp
I think I’ll leave it at this for today. Plenty of material for Halloween haters – enjoy!