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The Basics

Is technical analysis useful in the stock market?

statistics

A while back zigfred at The Polymath Investors wrote a 2-part piece (Part 1, Part 2) sharing his views on why technical analysis is of no use in stock market trading – at least by itself. His reasons are three:

  1. Its nature
  2. Its tools are flawed
  3. A lot of credible long term studies reveal that it does not work

OK, I have to address the last one first as being a non-argument.

Basically, he’s saying that technical analysis doesn’t work because studies have shown it doesn’t work. That’s not a causal statement at all. It’s like saying, “I can’t run a 100m dash in under 10 seconds because I’ve never been able to run it in under 10 seconds.” It’s providing evidence of the fact, not a reason why it’s true. As such, you can basically toss that out, but I won’t quite do that because the evidence needs to be addressed, which I do later.

Tackling things in their proper order, though, let’s start with #1.

The flawed nature of technical analysis
As zigfred rightly points out, the basis of technical analysis is market psychology. Taking that as given, he then presents the argument that on this basis, using technical analysis to trade the markets is a kind of recursive effort in that it turns back on itself because the act of using market psychology to trade influences that market psychology.

While it is certainly true that a definite issue with technical analysis is that it can create a kind of self-fulfilling market dynamic, zigfred presents things as if everyone is trading on technical analysis. Obviously, that’s not the case.

He also seems to be implying that trading on technical analysis is the cause for markets being more volatile than fundamental valuations would seem to suggest. In a truly efficient market – which zigfred seems to think one driven only on fundamentals would be – price would change relatively infrequently, only when new information arrives. Reality is far, far different. Even in the absence of technical analysis there are market mispricings. It’s the under/over-reactive nature of markets driven by individuals who are not perfect in their analysis of information and forecasting of future events. This isn’t even mentioning well-known psychological biases and other factors.

One need only look as far as the housing bubble for a major example. You can’t tell me that technical analysis was the main driver of that!

From a more market-specific perspective, what about the way prices react to data and news with sometimes extreme volatility? You cannot attribute that to technical analysis.

So while I agree that a market overly populated by technical analysis will tend to see TA losing its effectiveness, where fundamentals are still a major factor it remains a useful way to view prices.

Flawed technical analysis tools
The second argument against technicals zigfred makes is that the methods of analysis are basically no better than throwing a dart at a board. His major point is that even technicians don’t agree on which techniques are best or how to interpret charts and indicators.

Hard to disagree. There are a great many indicators out there that are derived from the fields of math and statistics and such which are either poorly understood or incorrectly interpreted. The same can be said of chart patterns and what the underlying causality of their development means. To my mind, this is largely a function of people failing to do the work and the study to really know what it is they are using to analyze the markets.

As flawed as the technical tools may be, let’s not suggest there aren’t major issues with the way fundamental analysis is applied.

Studies show that it doesn’t work
In zigfred’s post he specifically mentions a couple of studies which suggest that technical analysis methods don’t work. I’m not really surprised because I personally believe that rote application of the techniques aren’t really effective in the long run. The markets are too dynamic and changing for things to hold their usefulness consistently.

That said, however, academic research has consistently pointed out a momentum effect in the markets. I don’t have a reference at hand, but it came up a lot in the readings I did while developing my PhD thesis. Momentum in the academic usage of the term is basically trending. If there are trends that can be measured and anticipated, then at least one element of technical analysis has firm grounding in the research.

Now, this post is not me saying that technical analysis is the best thing. As you’ve seen, I’m quite willing to admit it’s problems. I just want to make sure the discussion is done on balanced terms. In my own stock trading I combine it with fundamental analysis. In other markets, and especially in shorter time frames, though, I rely on technicals more heavily.

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Reader Questions Answered

Budding student trader query

The following was posting on a trading forum site.

Hello all, im looking to start trading, i am going to try trading full time in July and August and then part time when i return to university in September. I have £1000 set aside to begin do you think this is adequate? I am going to take an aggressive approach and risk £300 per trade but pick my trades very carefully.

Just by way of clarification, this person is looking at stock trading.

How would you respond to this post?

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Trader Resources Trading Tips

Thoughts on CANSLIM

Last week I received an inquiry from a fellow member at Trade2Win.

I have your book and I think its great, im about half way through. I have read some of your posts here and think you give excellent consistent answers. I read that you are a canslim follower with a small deviation. Im not by any means looking for easy answers but the way I see it is surely canslim is too abvious and prone to manipulation to work in its pure form? I was wondering what your interpretation of canslim is, as I have much respect for your work.

What’s CANSLIM?
First of all, let me clarify what we’re talking about here. CANSLIM is the acronym for a stock trading system developed by William O’Neil, creator of Investors Business Daily (IBD). It can be found in the book How to Make Money in Stocks, which is now in its 4th edition. The original edition is one of the first books I read about when I was getting my start in trading and I still consider it to be perhaps the single most influential of all the one’s I’ve read.

To put it most simply, the CANSLIM approach combines technical analysis and fundamental analysis into one full long-only individual stock trading system. On the technical analysis side the focus is really only on chart pattern analysis. It doesn”t employ or even discuss indicators. As for the fundamental analysis, it is has both top down and bottom up elements to it, but is mostly the latter – focusing primarily on the companies.

Gaming the system
Here’s where the cynicism of the modern trader come in to play. The trader asking me about CANSLIM has suggested that it’s “too obvious” and “prone to manipulation”. I personally don’t see it that way.

To be sure, there is definitely some CANSLIM gaming that goes on, but it’s more about the lists the folks at IBD publish than the core strategy. There is a list of 100 stocks the IBD folks put out each week (I think) which lists the stocks they consider the best bets based on the CANSLIM criteria. Because inclusion in that list can generate a great deal of investor action in a stock, there are those who try to anticipate stocks joining the list and trying to profit from the bump new entrants can see. This, however, is a minor thing in the grand scheme.

Richard Dennis, creator of the Turtles, was reported to have said that he could publish his trading system rules in the paper and not have to worry about it hampering his performance. I’m with Dennis on that. There are millions of traders and investors using a vast array of methods for deciding what and how to take positions in the markets. Even the ones using the same system have variations in how they are doing so in terms of timeframe and instrument and such. On top of that, there are always those who simply can’t stick to the rules. We know this to be true. That’s one reason why I don’t see the CANSLIM methodology as being “too obvious” or anything like that.

Further more, CANSLIM is based mainly on intermediate and longer-term trends. These are not readily manipulated because they are generally founded in core fundamentals, like the trend in earnings.

Laying it all out
Those who have read The Essentials of Trading know that in the appendix I have posted the full stock trading methodology that I have used for many years and continue to use at present. As noted in the book, it has CANSLIM as the foundation. I’m not saying the CANSLIM methodology is for everyone. It isn’t. From the first time I read How to Make Money in Stocks, though, it made intuitive sense to me, and still does.

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Trading Tips

Defending Options Trading Against Blogger Attack

A fellow trading blogger wrote some things which really irked me. I’m not going to say who it was or link to the post as I normally do because basically all the guy does is plug his trading system in every post. He’s been on a multi-post rant about how people shouldn’t trade options or futures, or any other leveraged instrument for that matter. Two of the quotes this individual made in one of his recent posts in particular caught my eye.

With options trading, you need really good money management skills and many positions for diversification purposes.

If we took “options” out of the above sentence the first part of it would be fine. Good money management is a requirement of trading in ANY market. As for the requirements for diversification, to the extent that someone is going to diversify, it applies equally to any type of equity trading.

By the way, while investors who plan on long holding periods would do well to diversify their holdings, the same doesn’t necessarily hold for traders. In fact, the latter are better off keeping things concentrated so they can properly track their positions.

Since both options and ultra ETFs are about leverage, it makes more sense to go into ultra ETFs because they’re generally much safer than options and offer similar outsized returns.

I can’t help but wonder how the blogger is defining safety. If it has anything at all to do with the potential to take a loss larger than expected, then the ETFs are riskier than owning options, not safer. It’s a very simple thing. If you buy an option your risk is clearly defined. You can’t lose any more than what you paid. In the case of an ETF, however, you can easily lose more than you intended to risk because even if you use a stop there’s no guarantee of a fill at your exit price.

Now, if the blogger is equating risk to the odds of taking a loss, then that’s a different conversation. I’m still not going along with his take on things, however, because as I’ve previously noted in other posts, win % (or loss %) is not the sole determinant of performance.

I’ve said it before. It’s not leverage that creates risk. It’s how you trade. I personally prefer options for my equity trading because I can strictly define my risk and better manage positions on a running basis, plus they require less capital. That said, however, options suit the way I play the stock market. They will not do so for everyone.