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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

Technical analysis in manipulated markets

This originally went up on the Currensee blog, but I think it’s something that this audience will find interesting as well.

I threw the question of what I should write about this week to a former manager of mine who was a forex dealer back in his younger years and now makes a living telling folks what’s happening in the markets. He tossed back a surprisingly good question:

How can technicals be relevant when central banks are trying to manipulate the market- BOJ with USD/JPY and SNB with EUR/CHF?

I’m sure this is something that others have pondered as well.

Here’s my view on it – speaking as someone who is very much a practicing technical analyst.

Currency intervention by a central bank or other monetary authority (in the US intervention is directed by the Treasury, though it’s executed by the NY Federal Reserve Bank) is just another news item or event that influences exchange rates. Those of us who’ve been around the markets for a while have seen a great many dramatic market reactions to all kinds of developments. Some of them have been triggered by data releases. Some have been driven by news events. Some have been caused by speakers. And some have been the result of intervention action. Heck, some of the moves have come just from the suggestion of intervention without it actually happening.

In other words, intervention is just one more thing that is reflected in the price action we see on the charts. Furthermore, it’s also something that is incorporated into the market’s expectation of the future as part of the price action we’re seeing now. The more market participants anticipate intervention, the more they will factor that into their trading and by extension the more it will influence the price action we see. It works in the same way that stock traders will price in anticipated share buybacks or weak earnings. All markets are discounting mechanisms in some fashion or another, and we can analyze the patterns that are developed in the price action through that process.

So, from my perspective, I don’t view technicals as any less useful in a market where intervention may happen. I use the same methods I would in any other case.

Now, having said that, intervention certainly presents the potential for a major volatility spike on the event (or even the hint of it). If your trading strategy or market analysis is ill-suited to that kind of thing, then while that risk is in the markets you may be best advised to either change the pair(s) you trade or to lengthen your trading time frame out to one where sharp intraday moves aren’t so much of a concern. Alternatively, you could adjust your risk so that you have less exposure for trades going against the likely direction of intervention (like when going short USD/JPY if you think the Bank of Japan is going to sell yen). The analysis doesn’t change, but how you then use it does.

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Reader Questions Answered

Picking the right indicator(s)

This question came in the other day from a developing trader on the subject of technical indicators.

Dear Mr. Forman,

I’m a subscriber to your trading e-newsletter. I have a market question that I’d like to ask you. I often see it written on different market websites where they say that traders should use some kind of Technical Indicators on their charts to help determine the strength on a trend. I’m strickly a retail day trader (amateur lol), and mostly on using a 50 day moving avg on my charts and drawing my SR lines. I’ve tried lagging indicators like the RSI and MACD but they only seem to confuse me. I’m wondering which Indicators you think would be the most helpful to use for the shorter time frames that day traders trade in. Thank you so much and I look forward to your answer.

Germain

The first thing I’d point out is that all indicators are lagging in some fashion. Germain mentions RSI and MACD, but anything that uses historical data – and that’s all of them – has a built in lag effect to it. The further the look-back period, the greater the lag.

Now, certain indicators are meant to filter out the noise. Moving averages are in that category. They are meant to smooth out the ups and downs to indicate overall market direction. Longer moving averages will smooth out more volatility, but will be less responsive to market change, while the opposite will be the case with shorter averages.

RSI and other oscillator type of indicators basically tell you where the market is in reference to where it’s been. The idea there is that if it moves too far in one direction it will be overbought or oversold. The problem is that doesn’t work so well in a trending market.

To my mind, the best indicator of trend is the chart. Which way is it sloping? Stepping up a time interval from the one you’re trading to a higher one to look at the bigger trend can be very helpful. Again, you’re looking at history, so you there’s always a lag effect in your analysis (a trend will change before that change can be seen on the charts), but that’s just what we have to deal with.

No matter what I say, though, indicators (or the lack thereof) are an individual choice. We all have to pick things to look at that give us the specific information we require – and preferably no more than that. Decide how you want to trade and pick the things which help you identify trading opportunities or analyze the markets based on that approach.

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Trading Book Reviews

Book Review: Mastering Market Timing

[easyazon-link asin=”0137079303″][/easyazon-link]You want to learn how to identify stock market tops and bottoms? Then [easyazon-link asin=”0137079303″]Mastering Market Timing: Using the Works of L.M. Lowry and R.D. Wyckoff to Identify Key Market Turning Points[/easyazon-link] by Richard Dickson and Tracy Knudsen may be exactly the sort of book you’re looking for. It is a book with the sole purpose of showing you a set of techniques for spotting tops and bottoms as they are developing and estimating how far the reversal trend may go.

This is, however, very much a stock market oriented book. Some of the specific techniques can be applied in other markets, to be sure, as they are based on charting methods. Since volume and advance/decline information is also used, however, the unified approach outlined is not universally applicable across markets. Also, these methods are applied to daily time frame charts and higher, so they won’t be of much use on a day-to-day basis for short-term traders (though certainly they can be used to frame the larger market pattern).

As the subtitle indicates, the methods presented are based on those developed by Lyman Lowry and Richard Wyckoff. The latter name is one many technical traders and analysts are likely to know (Law of Supply and Demand, Law of Cause and Effect, Law of Effort vs. Result), but the former probably not as much. Both men developed their approaches to market analysis in the first half of the 20th century. Wyckoff’s focus is more on price/volume patterns, while Lowry brings market breadth into the equation. There is also a discussion of Point & Figure analysis. It’s mainly limited to use for projections, however, one should not expect a full education on the subject.

The book does a very good job of explain how these methods are used, both singularly and in combination. Market tops and bottoms going back to 1966 are examined in detail, providing the reader with ample opportunity to see how they work with real charts, not just idealized models. As such, I think [easyazon-link asin=”0137079303″]Mastering Market Timing[/easyazon-link] is an excellent educational resources for learning how markets form tops and bottoms and act during trending periods.

Actually, one of the bottoms outlined is the one from 2009. The book was written in early 2011 (charts are through February/March) and interestingly it projects a top in the S&P 500 near 1350. The index hit 1366 in May and revisited the 1350s in July.

Make sure to check out all my trading book reviews.

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Trading Book Reviews

Book Review: George Lindsay and the Art of Technical Analysis

[easyazon-link asin=”0132699060″][/easyazon-link]I was recently given the opportunity to pick up a copy of [easyazon-link asin=”0132699060″]George Lindsay and the Art of Technical Analysis[/easyazon-link], written by Ed Carlson. I was attracted to it by the reported quality of George Lindsay’s market analysis, though he’s not someone with which I was familiar prior to reading the book. He was a bit before my time in terms of when I started following the markets. 🙂

This book comprises a couple of primary parts. The first is a brief biography of Lindsay. It’s not particularly lengthy, however, as apparently Lindsay wasn’t someone well known on a personal level. He is known for his stock market newsletter writing back during the 1960s and 1970s. His market calls were apparently so good that key market followers of the time praised him very highly.

After the bio, the book gets into the featured technique of Lindsay’s – the Three Peaks and a Domed House chart formation. The author lays that out over four chapters. Although Lindsay didn’t really leave behind any singular technical manual type of explanation of the pattern, the author (Carlson) does do a pretty good job of teasing out the specifics from his writings on the subject.

The next part of the book covers The Lindsay Timing Model. This the application of “counts” to project market turning points. We’re not talking cycles here. It’s not about consistently repeating patterns, but rather taking a recently completed chart pattern and using it as the basis for a projection of a trend move timing.

The final section extends the counting element and brings in intervals and cycles. It also provides some case study evidence.

Now, it should be noted that the patterns and counts and whatnot discussed in the book are not short-term in nature. They are mainly based on daily bars and can take quite a while to unfold. For example, Three Peaks and a Domed House is a daily chart pattern which takes months to play out, though there are elements of it which could be traded along the way in slightly shorter-term ways.

Overall, I found the Lindsay work interesting. Readers familiar with Elliott Wave analysis will see some of those elements in the patterns described in the book. I would have liked to have seen more in the way of real world examples, particularly more modern ones. For someone interested in studying price action, however, this book could provide quite a bit of inspiration for research.

Make sure to check out all my trading book reviews.

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Trading Tips

Volatility Changes Across Markets

A recent blog post got me thinking about where volatility stands now compared to where it’s been. Here’s what I found for stocks and the dollar. Both of the charts below is a weekly which includes two measures for viewing volatility. Normalized Average True Range (N-ATR) measures average period high/low ranges (You can find articles I’ve written about N-ATR at Trade2Win and TASC). The Band Width Indicator (BWI) measures the distance between the Bollinger Bands, which is standard deviation of closing prices.

Dollar Index
Here we see that while volatility has certainly fallen well off from where it was during the worst of the financial crisis, it hasn’t quite got back down to average levels from before then. It’s worth noting, though, that volatility heading into the start of the problems in 2007 was ridiculously low. I don’t expect to see it get back to those kinds of levels.


S&P 500 Index
Volatility in the stock market, however, has now fallen back to about the same levels it was at during the middle of the last decade. This is something very important to keep note of because N-ATR tends to be low turning sustained uptrends, but rise into market tops.

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Trading Tips

Using Secondary Indications in Your Market Analysis

Yesterday Adam at Forex Blog put up a blog post looking at the British Pound, specifically in terms of GBP/USD. He throws a lot of different stuff into his assessment of the UK currency, part of which is looking at the prospects for a rate hike by the Bank of England. To that end, let me share two charts I keep an eye on in my work.

This first chart shows the spread of UK 2 year Gilt rates over the US 2yr Treasury Note rate, with the spread’s correlation to GBP/USD in red as the lower plot.

The second chart is the same as the one above, but swapping German Bunds in place of US Treasuries and running the correlation against EUR/GBP instead of GBP/USD.

I offer up these charts for a couple of reasons. One is to show the sort of secondary analysis professionals use to assess the markets. Another is to show how frequently market correlations can change. We would expect a positive linkage between the UK/US rate spread and GBP/USD and a negative one between the UK/German spread and EUR/GBP, but that’s not always the case.

The third reason for showing these charts is to show what’s been going on in these spreads lately. The UK/German spread has fallen sharply, strongly indicating the market’s view on whether it will be the ECB or BoE the moves first to hike rates has moved strongly in favor of the former. Things are less dramatic in the UK/US spread, but the breakdown there hints that fixed income traders have become less confident about a BoE rate move in the short-term in general, not just as opposed to the timing of the ECBs action. These are the sorts of things the professionals are looking at and thinking about in making their market judgements. It’s all related.