Technical Analysis: What It Really Is

Is Technical Analysis Useless or Is It the Only Thing You Need?

There are two types of people in finance:

  • Those who believe that technical analysis is useless.
  • Those who believe that technical analysis is the only thing you need for profitable trading (and that fundamentals and anything else are useless).

There is also the third type of people, who believe something in between (that technical analysis is not useless, if it’s used in the right way – not naively and not blindly). I am among them.

Technical Prediction

Technical analysis, the way it’s typically presented in the mass media, is very close to useless.

For example:

  • MACD is bearish and Stochastics is overbought and therefore Apple will go down.

It would be more suitable to call this technical prediction.

The problem with such prediction is that it makes you feel that Apple goes down every time MACD and Stochastics reach these values.

What Moves the Markets

Technical indicators don’t move markets

99.99% of time, markets do not move because of your technical indicator. Other market participants don’t watch your indicator and don’t know that the market should go down now because the indicator says so.

The remaining 0.01% is the kind of situations when the Dow is just approaching 10000 or 200-day moving average and almost everybody (and big media) pay attention to it – and even then, if the Fed suddenly comes with a surprise rate decision, the market will forget its technical levels and go where it will go.

Thousands of factors

Markets are affected by thousands of factors, because there are thousands of investors and traders making decisions for different reasons, motivations, and time horizons.

  • There is the technical analyst who sells because his indicators say overbought.
  • There is another technical analyst who buys because his indicators say uptrend.
  • There is the fundamental analyst who buys because the latest GDP or jobs data were better than expected.
  • There is the fund manager who sells because some of his clients want to withdraw money from his fund.
  • There is the trader who sells because he wants to close his position and call it a day, so he can join his friends waiting in a bar.

Knowing All the Factors and Motivations Is Impossible

A single person or a single investment team (even if they had the best computers and software in the world) can’t know all these different factors and motivations. It’s like knowing what everybody in your city is doing or thinking about at a particular moment – impossible, although sometimes you can guess what big part of them are doing (based on time of day, weather, or upcoming holiday).

Because we can’t know everything, we must make trading decisions with imperfect and incomplete information.

What Technical Analysis Does

Technical analysis makes the information we get from the market:

  • Simple – so we can process the information quickly and make a trading decision before the opportunity is gone (and if you place 14 different indicators on your chart, you are giving up this benefit)
  • Quantifiable – so we can process the information using computers (it is a must for systematic traders, but it also helps a lot even when you’re discretionary)
  • Comparable – so we can identify similar situations in the past or in other markets

How Technical Indicators Transform Market Information

For example, what do the oscillators (like Stochastics, %R, or RSI) do? They don’t predict future price moves. But they remove a part of market information that we don’t need at a moment (e.g. volatility or absolute price level) and only show us what we do need at the moment (where the market is relative to N latest periods).

What do moving averages do? They remove a part of market information (e.g. volatility and short-term noise) and only show us the overall direction (trend) in price over the last N periods.

Why We Want to Transform Market Information in This Way

With this simplified information, we can identify similar situations in the past and we can estimate the approximate odds of a particular price move, based on the past.

For example, you see that 20-period RSI had been above 80 for 10 days in a row and now it dropped below 80. You find other days in history when RSI behaved like this and see what the market did after. You can see average profit or loss of a particular trading strategy or distribution of the market’s returns (knowing that is useful for trading options). If you have the market data, this kind of analysis takes a few minutes in Excel.

Technical Analysis Is a Subset of Quantitative Analysis

Quantitative analysis (identifying potential trading opportunities based on historical market data) is the key part of Macroption Research. Technical analysis, as I understand and use it, is part of quantitative analysis.

Technical Analysis, Quantitative Analysis, and the Big Picture

Although history often repeats itself, sometimes it doesn’t. Because markets move under the influence of thousands of factors, every moment is unique. There will never again be the same day as today, even when a particular indicator will show the same value. Therefore, the odds or return distributions you get from analyzing historical market data must not be relied on blindly. Quantitative analysis works best when complemented with some common sense – some regard for current market environment and for factors which are harder to quantify (like news, fundamentals, and overall macroeconomic climate).