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.

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?

Trading Book Reviews

Book Review: Broken Markets

[easyazon-link asin=”0132875241″][/easyazon-link]In the retail foreign exchange market there is a long history of complaints about brokers taking advantage of customers to their own benefit. Having now read [easyazon-link asin=”0132875241″]Broken Markets: How High Frequency Trading and Predatory Practices on Wall Street are Destroying Investor Confidence and Your Portfolio by Sal Arnuk and Joseph Saluzzi[/easyazon-link], I can’t help but think things in the equity market are so much worse. At least in the forex market the types of front-running and conflict of interest activities the book talks about tends to draw the attention and ire of the regulators. In the US stock market, though, this stuff and worse is going on at the hands of high frequency trading (HFT) systems, and it’s largely thanks to regulatory changes that have been made over the last number of years. Not only that, but nothing has really been done to prevent another Flash Crash from happening. At least that’s the takeaway I get from reading this book. It’s an eye-opener.

We’re not just talking about front-running, which was a complaint often aimed at the old specialist system. We’re talking about what information is being provided to which market participants and not to others. We’re talking about the way orders are being routed and how brokers are being paid to send orders to specific exchanges and/or dark pools. It’s no wonder so many individual investors think it’s a rigged game!

Now, as much as there’s a lot of really interesting (and potentially horrifying) information and ideas in the book, it is a text with a clear agenda. The authors are advocates for change – in some cases a reversion back to prior market structures. They make good arguments (and there are copious footnotes), to be sure, but as someone who doesn’t have a deep knowledge of the mechanics and inner workings of today’s equity market, I would personally need to hear from the other side of the debate before forming my own position on specific proposals. That said, the case I have heard made in the media in support of HFT in terms of added liquidity, etc. thus far is not sufficient to overcome the objections presented by the authors of Broken Markets.

As much as this book is a good argument for a change to the system and the need to rein in HFT, however, it gets marks off for how it was written and structured. There is a lot of repetition of ideas and arguments. It has the feel of a book comprised of a collection of articles rather than being something purposefully written. The inclusion of a couple of guest chapters furthers that impression. While I haven’t (yet) read the white papers written by the authors (they are included as an appendix), I get the distinct impression most of the book comes right out of them. As a result, I can’t help but wonder if it wouldn’t be better to just read them and not bother with the book. The white papers can be found on the web, and the authors blog regularly on the HFT subject.

So the bottom line is that [easyazon-link asin=”0132875241″]Broken Markets[/easyazon-link] has a lot of important information and ideas, but isn’t the greatest book because of how that stuff is presented, so I give it a middling rating overall.

Make sure to check out all my trading book reviews.

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?

Trading Book Reviews

Book Review: Buy and Hedge

[easyazon-link asin=”0132825244″][/easyazon-link]While it may be generally classified as an investing book [easyazon-link asin=”0132825244″]Buy and Hedge[/easyazon-link] by Jay Pestrichelli and Wayne Ferbert could easily be classified as a trading book because of the way it advocates the use of options. I’ll leave the reader to classify it for themselves, though, based on their own definitions of the two terms.

In a nut shell, the philosophy of Buy and Hedge is that any positions one takes in the stock market (and we’re really talking long-only here) should be hedged. Individual hedging is best, but portfolio hedging is also considered acceptable by the authors. Options are the favored tool to accomplish that hedging.

About the first half of the book puts forth the reasoning and justification for hedging. Mainly it comes down to reducing the volatility of your returns. The authors make the statement that the one thing you can control in the investing process is the risk. I’m not totally comfortable with putting it that way, but I get the point they are trying to make.

The second half of the book is focused on options and option strategies which can be used for hedging purposes. In fact, the authors go so far as to recommend strategies (though not necessarily in all cases) where no position in the underlying security (stock, ETF, etc.) is held – the position is totally created with options. This is probably something that will make traditional investing advocates a bit uncomfortable.

It should also be noted that the authors don’t have anything against a straightforward index approach. They just think that it should incorporate a hedging element.

All in all, I think [easyazon-link asin=”0132825244″]Buy and Hedge[/easyazon-link] is a worthwhile read for those who favor playing the stock/ETF market from a longer-term position perspective.

Make sure to check out all my trading book reviews.

Reader Questions Answered

CANSLIM and market trend

I received the following query from a Trade2Win member the other day.

I was just re-reading the example strategy part of your book. I know you said it is inspired from CANSLIM. O’Neill generally advises staying out of the market if it is in a bear trend. Do you generally find this affects your strategy. Do you have to leave it for another or do you find it still works fine possibly with less candidates?

My personal experience with stock trading in general, and CANSLIM-related strategies in specific, is that the overall trend of the market is a major influence on the performance of most individual stocks. I think most experienced traders would back me up on this. Also, there’s been a lot of talk lately about how much more correlated individual stocks have become to the indices of late, so it would seem these days the O’Neill suggestion should be taken even more seriously.

While it’s certainly true that strong stocks will tend to outperform the market no matter the overall conditions, there’s an aspect to CANSLIM which needs to be accounted for here. The stocks identified tend to be high beta names, meaning they tend move move more aggressively than the overall market. That’s great when the market is rallying, but it can be a killer when the market’s moving the other way.

Trading Book Reviews

Book Review: Laughing at Wall Street

[easyazon-link asin=”0312657854″][/easyazon-link]Books by successful traders and investors seem to be eagerly consumed, and with a title like [easyazon-link asin=”0312657854″]Laughing at Wall Street: How I Beat the Pros at Investing (by Reading Tabloids, Shopping at the Mall, and Connecting on Facebook) and How You Can, Too [/easyazon-link], I wouldn’t be surprised if this one by Chris Camillo is as well. Camillo’s claim to fame is running $20,000 up to $2 million in three years trading the stock market. The book describes his methodology for doing so.

It should be stated that the author’s approach to the markets is not dissimilar to the one suggested by Peter Lynch in [easyazon-link asin=”0743200403″]One Up On Wall Street[/easyazon-link] many years ago. Lynch, who was the wildly successful manager of Fidelity’s Magellan fund, suggested using what you know to invest in the stock market. Camillo takes the same approach, though brings modern developments like Facebook and online forums into the discussion. The book does a good job of describing the thought process which needs to be at work and how one needs to go about things.

The major wrinkle the author introduces here is the use of options. This is where we really go from this being an “investing” strategy based on identifying mis-valued stocks to a “trading” one which employs leverage, albeit a fairly simple one based strictly on plain vanilla long call and put positions. Of course its takes considerable aggression to increase an account 100-fold in three years, especially when working on a valuation type basis where positions aren’t entered frequently and take time to make the big moves. This is no day or swing trading strategy. The author looks for the moves to take 6-9 months or longer to unfold.

The aggression goes beyond just using options, though. Camillo takes on position sizes which would leave most traders in a cold sweat – like putting half his account in a single option. His doing so, however, is rooted in the way he funds and views his trading account. It is truly risk capital only, totally separate from his long-term investing funds. His concept of OPM is one worth thinking about for many new, low-capitalization traders. I venture to say, though, that even in this case it takes a certain mentality to be able to risk the loss of half one’s account in one single trade.

My biggest gripe about the book was the author’s constant sniping at Wall Street professionals throughout the book (he also tears into both technical and fundamental analysis, though his strategy would clearly be classified as the latter). The point was made plain enough early on that individuals can take advantage of things overlooked by the pros, with which I fully agree. There was no need for continued pot shots through the rest of the text.

The other issue I had was the failure to include a discussion of the impact of volatility on option prices. I’m on the side of those who don’t think options trading needs to be nearly as complicated as some tend to want to make it, but those thinking to trade them should understand the volatility influence. Camillo discusses intrinsic value and time value, but in his description the latter includes volatility. It could be said, though, that given the length of hold period and the types of moves he’s after, it’s not really a major issue.

Those two complaints aside, I do think [easyazon-link asin=”0312657854″]Laughing at Wall Street[/easyazon-link] is a good read. It provides support for the ability of individuals to do well in the markets and offers up an interesting concept in the author’s concept of Other People’s Money (OPM). The strategy requires work and effort, and perhaps the risk-taking aspect would need to be adjusted to individual tolerances, but overall the approach is a very reasonable one.

Make sure to check out all my trading book reviews.