Posted by: Bevan | December 18, 2011

Technical Analysis Fallacy

Technical Analysis certainly is an approach to the markets which engenders a variety of responses which I think I’ve discussed on here before. My systematic mechanical approach is of course technical in that it is based upon an analysis of price. However some of the criticism of Technical approaches is valid – generally most of the derived familiar indicators (Stochastics/RSI/Bollinger Bands) used in familar ways don’t make money on their own (see the interesting chapter in The Ultimate Trading Guide for some test results along these lines).  What most people miss is that the sort of technical analysis you read about on a lot of blogs and forums where people are looking at lines and indicators to make predictions is valueless as a moneymaking tool.  Instead these indicators have to be used as components in a fully considered and tested trading system.  That is a business plan that incorporates market selection, trade sizing, a setup, an entry trigger, risk management during the trade and an effective exit.  RSI for example might be a great component in designing an entry trigger as part of a system, although its useless on its own either to generate profitable trades with a good Risk:Reward ratio, or to foretell whether the Euro will go up or down.  Really that is the key to a trading system, a method of decision making allowing a trader to enter trades which over time result in profits due to low risk entries which tend to produce larger winners than losers.  I will post some up to date results here soon based upon the original principles, updating John Hill et al’s work.

Performance of a system buying when RSI is below 30 (oversold) and selling when above 70 (overbought), source “The Ultimate Trading Guide” by John Hill, George Pruitt and Lundy Hill, 1999

Occasionally when I have nothing better to do I enjoy reading some of the Internet trading forums that I used to follow religiously in my early days searching for sage advice and the perfect strategy.  One prominent thread on ForexFactory is entitled Technical Analysis Fallacy and has been running since November 2007.  Like many Internet forum threads it consists of a ‘guru’ (fti) and a collection of acolytes and faithful followers who perpetuate his wisdom.  Allegedly “FTI traded at the top of his field, overseeing and educating a Tier I Bank”.

Reading the first post its actually fairly sensible, but seems to develop into a lot of nonsense and silly terminology designed to make it as difficult for newcomers to understand as possible, leading to more awe about fti and the complexity of his ideas, and greater dependence on the acolytes to explain issues (if they can be bothered).  Newcomers are recommended to start with the first 200 pages of the thread before they go any further.  They have to deal with baffling prognostications (much of it based upon The Art of War) such as “The efficiency ratio, from personal experience for me is a skew of the pi but of course you are not required to mimic me, as I have balls of steel from my training” and “What you can do is to acertain that during critical sectorial zonal change of guards you must be able to spend some time on trying to decipher whats happening to market trend on a macro basis” .  Additionally averaging down is part of the methodology that develops, a sure way to the poorhouse.

It certainly is easy to get entrapped in the constant search for perfect entry methodologies, and wrapped up in fuzzy headed thinking.  I believe the most useful thing for beginning traders is to gain an understanding of the market and how and why it moves, get their headspace sorted then get an understanding of all the components of a successful system.

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