The Basics

Is technical analysis useful in the stock market?


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.

The Basics

Is there such thing has hybrid trading?

decisionPhilosophical question: If you trade partly in a mechanical fashion and partly in a discretionary fashion, are you really trading mechanically at all and not just discretionary?

I ask that question after re-reading an old article on the subject of hybrid trading, which is described as combining mechanical and discretionary approaches. The piece takes the view that mixing the two approaches can serve to counter the issues which each of them have individually.

In terms of the mechanical approach, the advantage is suggested to be that such systems provide very clear signals and thereby reduce the opportunity for psychological issues cropping up to derail our performance. On the negative side, however, sometimes mechanical signals can completely conflict with the market view we’ve developed. Whether that’s a bad thing is open to interpretation, though. 😉

The reported advantage of discretionary trading is that it allows us to trade in a way which may better account for current market situations. The short-coming, though, is that such an approach can be subject to psychological problems, as well as a simple lack of market understanding.

The article goes on to basically describe hybrid trading as being an approach in which the trader decides which signals provided by a mechanical system they will take and which they will ignore. Doesn’t this basically sound like a bad implementation of a mechanical system?

Personally, to my mind if there is any kind of discretionary element to the trading process, particularly with respect to entry and exit, then I consider it a discretionary approach overall. This does not mean there can’t be mechanical aspects, however. There certainly can.

In fact, many discretionary traders are mechanical in the way they approach things like position sizing and risk management. Setting trade account exposure at 1% is an example of this.

Stock traders often use filters to narrow down the number of companies to look at for consideration. That’s another example of a mechanical process in what can be a very discretionary overall approach.

So does having a mechanical element to your otherwise discretionary trader make you a hybrid trader? Or does it just make you more efficient?

The Basics Trader Resources Trading Tips

More than just basic free trading advice

In the process of preparing for the review of Hedge Fund Market Wizards I posted yesterday I went back and read some of the reviews of prior Market Wizards books. I have long been an advocate of the series, and remain so with the addition of the new book, it’s worth seeing what those who don’t agree have to say. Their arguments against one or more of the books help me produce a better review.

Now folks are going to have their own opinions. I’ve got no problem when people disagree with me. I did, however, see a couple of repeated version of the following comment that I have a problem with:

I dont understand what really gets those books so many positive reviews. Seems people dont surf internet to get some basic free trading rules like “Let your winners run”, “Cut your losers”, “Dont add to losing positions” etc etc.

Its all virtually the same FREE information spoken by different people!

That one came from a 2010 review of [easyazon-link asin=”1592803377″]The New Market Wizards[/easyazon-link]. I saw similar comments from other reviewers of the different books, so it’s not just one person’s view.

Has it never occurred to these folks that the Market Wizards books are a major (perhaps the major) source for those rules? Obviously not.

Yes, there is a great deal in these books which can be called common knowledge at this point. It wasn’t so common back when the books first started coming out. Believe me. I was a new developing trader in those days. This was eye-opening stuff.

It’s a question of context, though. Reading that you should cut your losses on some website, in a forum, on in a book about trading is one thing. Getting the same advice from someone who can tell you why and provide you with vivid examples of what happens when you don’t from their own experiences is a whole different thing.

But the Wizards books are about more than learning rules. They can also be a great way for someone trying to find their niche in the markets to get a broad survey of different ways successful traders approach and think about the markets, potentially giving the reader something they can latch on to for their own trading.

The Basics

The Primary Trade Size Forumla

Position sizing is something that comes up ALL THE TIME in the discussions among new and developing traders. Everything starts with the size of the risk we’re looking to take and works up from there.

Here is the basic formula:

Position Size = Amount at risk /(Number of Points or Pips being risked x Value of  Each Point or Pip)

Amount at risk comes from looking at the fraction of your account that you want to be exposed to loss on the given trade. So if you have a $5000 account and want to risk 2% then that would be $100.

The number of points or pips being risked is basically how far away from your entry point your initial stop will be. If you’re getting long at 100 and your stop is at 95, then the point risk is 5.

The value of each point or pip will depend on the market you’re trading.

Thinking in stock market terms where the value of a point is $1.00 per share (adjust for your own currency), the formula would be as follows:

Shares = $ to be risked / (Points risked)

So if you want to risk $1000 and your point risk is 10 you would trade 100 shares: $1000/(10 x $1)

If you’re trading a fixed size contract market such as futures or forex (lots), then it would look like this:

Contracts (Lots) = $ to be risk / (points risked x point value)

In the case of e-mini S&P 500 futures, the point value is $50, so if we want to risk $1000 and have a 10 point stop, we would trade 2 contracts: $1000/(10 x $50)

If we are trading micro lots of EUR/USD where the pip value is $0.10 and we are risking $1000 with a 125 point stop, we’d trade 80 contracts: $1000/(125 x $0.10)

Notice that nowhere in here did I bring up the question of appropriate leverage. It only matters if you don’t have enough available to you to put on the trade you’re looking to do.

The Basics

What do you trade and why?

A question came up on Trade2Win recently on a new thread. It asked the question of the membership, what do you trade and why? In many ways this is a fundamental question that every trader needs to have a strong answer to in order to be on the right track. So to that end, let me address it for myself.

I have traded just about everything you could think of a retail trader trading. Basically, it’s about finding good opportunities. I’m primarily a technically driven trader who operates mainly in the swing to position time frames, so I don’t need to have the narrower focus of someone who trades in the shorter time frames.

That said, stocks and forex are my two main markets.

In the case of stocks, that’s what I came up following. Back in the 80s when I got started it was still the main market available to retail market participants. I didn’t have the funding to effectively play in the futures market (there were no mini contracts back then). Also, when I read [easyazon-link asin=”0132825244″]How to Make Money in Stocks[/easyazon-link] it really resonated with me in terms of approaching the market. The strategies I use to this day have a foundation in what I learned from that book.

I got active in forex in the early 2000s. This was as online trading was really starting to develop and I was covering the forex market professionally at the time (as I am today). I liked that I could trade at any time of day or night, which you couldn’t really do in other markets at that time. I also liked how technical the forex market was. It suited my trading orientation very nicely.

These days my #3 is stock indices. I go through periods where I will lock in and fairly actively trade the likes of the mini S&P 500 futures. It’s very much a market conditions and available focus sort of thing, though.

What about you? What market(s) do you trade and why?

The Basics

Twenty-four Hour Forex Volume Distribution

The question of volume in the forex market is a common one seeing as there is no one central aggregation of the data. I happen to work for a company that has a major forex dealing platform in it, so I get to see some stuff that isn’t available to the public. One of those things is how volume is distributed throughout the day.

Here’s a graph of EUR/USD volume based on Thursday’s trading (times noted are in GMT).

The pattern is pretty obvious. The volume in the Europe/US overlap is the most significant. Outside of that it’s markedly lower.

And to provide a perspective on a currency that would be thought to have a more regional bias, here’s AUD/USD.

Here we see more of an Asian time frame volume spike, but still we have to look at the US morning as the biggest volume period.

Of course this is just one day – a day when there were important data releases in both the US and European mornings, which is reflected in the spikes we see in EUR/USD. Other days will show different distributions. The primary pattern of heaviest volume in the overlap will basically always be there, though.

The Basics

A little quiz on trading returns

A book I’m currently reading (which will be reviewed later) presents a set of choices to the reader in terms of picking which sequences of market returns is the better choice. Let’s see how well you do.

1) Which set of returns produces the better final return?
A) -30%, +30%, -30%, +30%
B) -10%, +10%, -10%, +10%

2) What if we switch the sequence around?
A) +30%, -30%, +30%, -30%
B) +10%, -10%, +10%, -10%, +10%

3) How about adding an extra period?
A) -30%, +30%, -30%, +30%, +15%
B) -10%, +10%, -10%, +10%, 0%

4) What about if there are no negatives?
A) +10%, +10%, +10%, +10%
B) +20%, 0%, +20%, 0%

If you answered B, B, B, and A then congratulations!

If you did not, then you probably fell victim to thinking of the returns as being additive rather than multiplicative. By that I mean the final returns for question 1 are derived as follows:

A) 1 x (1-0.3) x (1+0.3) x(1-0.3) x (1+0.3) or 1 x 0.7 x 1.3 x.7 x 1.3 = 0.8281 or -17.19%
B) 1 x (1-0.1) x (1+0.1) x(1-0.1) x (1+0.1) or 1 x 0.9 x 1.1 x0.9 x 1.1 = 0.9801 or -1.99%

And because it doesn’t matter which order you do the multiplication in, the results for question 2 are exactly the same.

In the case of question 3, the added 15% return in period 5 isn’t enough to overcome the prior period’s ups and downs as 0.8281 x 1.15 only brings it back up to 0.9523.

For question 4 it’s again a simple pair of calculations

A) 1 x 1.1 x 1.1 x 1.1 x 1.1 = 1.4641 or +46.41%
B) 1 x 1.20 x 1 x 1.20 x 1 = 1.44 or 44%

The point the book authors are trying to make is the volatility impacts performance. The extension from there is that using risk management to at least reduce the size of your losers can increase your returns significantly.