Friday, February 19, 2010

IS TECHNICAL ANALYSIS FOR IDIOTS?

I wanted to bring up the ongoing conflict among two schools of thought - fundamental analysis and technical analysis.

A common question that needs to be answered is "Does technical analysis work"? As a discretionary technical trader with 8 years under my belt, I feel that it is my responsibility and obligation to defend technical analysis as a legitimate and effective approach to profitable trading. I use technical analysis every day, demonstrate it's effectiveness, have the returns to prove it, and I will champion this form of analysis till the day I die. As "The Chart Addict" nothing less should be expected.

This article is for all of the non-believers, bashers, those holding myths about TA, those that don't truly understand TA, and for the unfortunate ones - those that lost money and blamed it on TA. The truth is, I could really care less what you think about TA because it works for ME. Perhaps it doesn't work for you, and that's perfectly fine. We all trade the markets in different ways, and it's important to use what works for you. If something simply does not "fit" with you, then you should explore other options. This goes for both TA and FA (fundamental analysis).

Technically Speaking

Technical analysis, in it's most simplest form, analyzes supply and demand through price and volume action. TA is designed to help you identify the most probable future action based on price history. Note that I did not say that TA is used for predictions the way most people would think. There are jokes that using TA is "voodoo", "similar to using a crystal ball", "black magic", "hogwash", "hocus pocus", and whatever else you may have heard. The people that think like this truly do not understand what TA is and how it is properly used. I encourage you to open your mind and explore this realm. For those that have been following me for 1-2 years, you know that I champion TA as my most favored trading analysis.

We are NOT trying to find out the value of a company, and in most cases, we don't care. We don't sit here reading 50 page reports day and night. Most technical traders have short-term horizons (day/swing) and technical analysis, in my opinion, has the upper hand for these shorter time frames. Furthermore, there are enough technical analysts that have consistently demonstrated the value of this art.

Proven Success with Technical Analysis

Since I made my Covestor account on March 17, 2009, I still command a return north of +300%. Am I lucky? You have to be really dumb if you think that. In fact, returns for my last 4 years all exceed +100%. How is that luck?

The Stocktwits community is full of tens of thousands of traders, but there are quite a few that I will personally recommend to you. Time and again, these folks have demonstrated exceptional and consistent skill from the proper use of TA: Brian Shannon, Anne-Marie, TheEquilibrium, DowntownTrader, ZMoose12, Steven Place, Kunal, ldrogen, Stewie, John Welsh, Trader Florida, Tickerville, SMB Capital, Zortrades, Misstrade, Gtotoy, and many, many others. The list is too long, but the point I'm trying to make is "how can technical analysis be rubbish if there are SO MANY successful technical traders"?

Still have something to say? Before you say anything, first prove your returns and then we'll talk or GTFO.


Arguments

So, you still don't believe that TA works. Maybe it's because you subscribe to only one school of thought. Or, maybe you buy an academic's theory of efficient market hypothesis. For those that don't know, efficient market theory states that the current price is right and past information is already reflected in the price of a stock, therefore analysis is useless.

There are three sub-arguments with this theory. There is the weak, semi-strong, and the strong forms of efficiencies. The weak form states that any analysis into the history of price movement is useless. The semi-strong form states that fundamental analysis is also nearly useless. The strong form states that all information is already reflected into a stock and neither schools of analysis will help you.

Here's another "argument": "Charts are just full of stupid squiggly lines that have no meaning". Seriously? Each price bar is important. They show you the open, close, high, and low. Put these bars on a chart, and you have a pictorial representation of all market participants. As a technical trader, I am more concerned about how other market participants are behaving and their reactions. A good example of this is with earnings releases. A company could report stellar earnings, but the stock could gap down. Also, a stock could report a huge loss, but gap up. In some cases, a stock barely moves. The chart shows me what other traders are thinking, and that has huge value in itself.

How about "throwing darts on a dartboard"? This is false. Expert technicians sort through hundreds of charts to assemble only a few that are worth playing. Only charts with the best setups make the cut. How is this throwing darts? Are we lucky? Sometimes, but we don't rely on luck. We rely on concrete data presented on the charts (price, volume, MAs, support, resistance, channels, gaps, etc). Remember? Charts are created by the collective participation in the market or stock. There is significant value in analyzing the psychology behind their behaviors.

There are many arguments, and if you have one to PROVE that technical analysis doesn't work, then leave a comment and explain your thoughts. Key word is PROVE.

Reading the Charts

A problem with technical analysis comes in the way people interpret charts. Two people can look at a chart but have different opinions. How is this possible? We are human, we have biases, and we all have different opinions. The key is to look at a chart for what it is. I've seen people draw phantom trend lines that don't exist, probably because they have a position in the stock. Manipulating a chart so that it favors you is the wrong approach to analyzing charts (and you are also lying to yourself).

Charts do not lie. They show what has happened already, and it's all real. How many analysts do you know of are guilty of sticking their personal opinions in their reports? Countless. Funny thing is, many stocks with multiple firm coverage often have conflicting opinions amongst each other. What and who are you supposed to believe? The answer is to believe in only yourself. Use technical analysis as a way to make your decisions without emotions.

Charts don't move the markets, but people do. People can say anything, but what is reflected in each price bar represents what people do. People's actions form the chart. Your trades, big or small, help create the chart. So then, does it make sense to bash charts when your trades are reflected in them?

Entries and Exits

If you still have doubts about TA, please tell me how you enter and exit your trades. How accurate and consistent are you? Do you sometimes have to "wait for things to work out"? Technical analysis, among the two schools of thought, has the advantage of lower-risk timing. Keep in mind that technical analysis is highly favored by short-term traders, thus accurate entries and exits are more important to us. Generally, the longer the time frame, the more important the fundamentals. It all comes down to the individual and his/her methodology and style.

If you are a pure fundamental analyst and you are attacking technical analysis = "apples to oranges".

Follow the Big Money

Most institutions either do not use TA or do not make it a priority. Does this mean that TA is insignificant? No! Expert technicians can follow the footsteps that are created by institutions. A good example is playing momentum breakouts on high volume - prior to the breakout.

Co-existence

Many traders favor a hybrid approach of implementing both fundamental and technical analysis. I believe that this is a very powerful method of trading and it is highly recommended.

In conclusion

There is no wrong method, as long as it works for you. For me, technical analysis is my foundation and it has worked for me all these years. I would not be writing this article if I believed TA and charts were worthless.

Use what gives YOU the best advantage.

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-John Lee aka "The Chart Addict"

Twitter: @WeeklyTA
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