Why does technical analysis work. (does it?). And other general trading questions.

[neil9327]

I must apologise as my post got rather long-winded, and contains several questions embedded in it.

1. Technical Analysis. I don't understand how this works, and I don't know whether it works. Surely the large banks and fund managers with their vast arrays of knowledge, computer power etc would have worked out all the trading situations where there is a good back-tested long term profit, and traded the markets with large positions such that at all times prices will have moved to a level where these opportunities no longer exist.

One possibility as an answer to this, which is a pure guess, is that maybe these banks don't give free-reign to their in-house technical analysts to use sufficient capital for this purpose, instead preferring to allow their traders to run the show, using technical analysis only where the traders deem it necessary to do so, thereby allowing many opportunities to go unused by them (and therefore available to "us").

One thing that backs up this view is that I was talking to a mathematician a few weeks ago, who worked to provide technical analysis advice to traders in a large bank, and I asked him whether technical analysis worked. And he said yes it does, but he implied that the traders he gave it to often did not take his advice. And I suppose the implication is that there was no in-house dedicated technical analysis trading plan.

Interestingly he said to me that a good time to trade is in the last 10 minutes before the close. I can understand this because some day-traders will be closing their positions then, so there will have to be some potentially predictable volume and price movements I would have thought.
Does anyone have any resources/books that talk about this aspect of trading?

2. Who is in the market? If it is true that 80% of traders lose, and 20% of traders win when trading, then this raises the question of who are these 80% of traders. Obviously many of them are beginners, but are there some who have been trading for some time. If this is the case then why do they continue. Is it the banks who employ them being stupid? Or private individuals who don't realise they are losing money.
I am making the assumption that trading is a zero-sum game - this is the case isn't it (OK there is the effect of dividends I suppose, but does this affect this balance much?)

I think I am correct when I say that the banks are making millions from trading. So their traders must be in the 20%.
Therefore are we really saying that the millions of pounds being made by the banks and other "20%" traders are coming solely from the trading errors of the 80% traders - the new entrants to trading?
And following on from this, if these new traders manage to lose consistently or semi-consistently, isn't one good trading strategy to find out what they are trading, and putting on the opposite trade, so that for every pound they lose, you make?

I guess there are other market participants, such as (for commodities) farmers who want to hedge the value of their farm produce against delivery in 3 months. If the "trades" that these people made were added up over all time and all trades, did they make a profit, break even, or lose. In other words, were the actions of the 20% good traders sufficient to move prices in such a way as to cause these people to lose.

Many other questions, but I'll stop before people fall asleep.

My name is Neil. I am an occasional trader, putting around 8 trades on the FTSE a year for the past 6 years. I am up £10K overall, which is a small profit I guess.

 

[damianoakley]

Hi Neil,

Good post, but yes very long ! - just kidding.

I suspect there will be a few traders on here that will want to give opinions on what you've queried. Here are mine:

1) Technical Analysis is a tool that can work when applied correctly, so it isn't true to say that it either works nor doesn't work. It works for some - it doesn't work for others. In my opinion, technical analysis is a useful tool, but is no substitute for looking at actual price action. Different traders will apply varying types of technical analysis tailored to their trading style.

2) The market is traded by large financial institutions (like pension and investment companies), long-term investors, short-term speculators, and retail customers who are buying and selling the actual market product, rather then tyring to profit from price speculation. As regards the "80% unsuccessful" statement, I would say that this is the same as any other business venture - ie - around 75% of business fail within 5 years.

As for the final profit figure you mention at the end, it depends on how much trading capital you are using. If you started with £1000, then 10k is a great profit !


Thanks

Damian

 

[Tubbs]

In my opinion Technical analysis doesn't work and there is always a fresh supply of money from stupid people like ourselves to feed the fire. The only money made is in transactions. That's why the industry wants us all to trade. Great con. My incredibly simplified view.

 

[FXSCALPER2]

Does TA work? If you are asking whether technical indicators perform better than chance, the answer must be 'no'. Using a TA tool with 1:1 ratio, meaning put a trade on with equal stop and limt orders, over the long run, I am sure you won't do better than chance.

I can never understand why people assume people who work for banks are super traders. I bet they are, on average, as crap as any Joe. Read Lipschults' interview in NEW MARKET WIZARDS.

Does this mean you can't make money trading? No, of course it doesn't.

 

[neil9327]

Thanks for that Damian,

1) I don't understand why one cannot be black and white about judging the merits of any specific Technical Analysis (TA) strategy, and only include in the list those that work. Surely the reality is that for a specific TA based trading plan then in the long term it will either work, break even, or lose money. And therefore if it has long term made money, it is highly likely to long term make money in the future, so is worth trading. Of course there are other factors such as drawdown - if a strategy has long periods of continuous drawdown (periods of losses) then it is probably unwise to trade (unless indeed these drawdown periods can be predicted).

I don't understand why a particular TA strategy should as you put it "work for one" and not for others. Surely if each trader implements the strategy correctly they will both get the same results?

2) I understand what you are saying about a major part of the market being investors such as insurance companies and pension funds, with "us" traders as another part, and professional traders working for the banks as another.
So I wonder, if you lump all of "us" and the professional bank traders into one unit, do we on average make money on short term trading? If so, then this suggests that the counterparty to this trading activities which is the pension funds and insurance companies must be losing money on the short term parts of their stock market activities.

You say most companies fail within 2 years. I understand that this is mainly because of cashflow problems. Perhaps there is a parallel with this with real traders, that many of them make profits, but too many of them lose their entire trading capital in a particularly bad run.


3) My total trading equity started around £120000 and so my trading to date has been to put positions on to this level - i.e. £20/point or thereabouts. So the FTSE could fall to zero and I'd still not be kicked out of the market.
My strategy was always to put long positions whenever www.ft.com carried a headline saying "the FTSE dropped xx points today due to fears about xyz" Since fear is an irrational and temporary emotion I reasoned correctly that after 3 days or so the fear would lift and with it share prices regardless of underlying conditions.
This has happened 6 times this year, and with this strategy I have made around 6 bets at £20/point and each one has made £1000 on average, with no losses.
Looking back on 2006 on a chart, from a TA perpective, I was buying on a pullback on an upward trend, so was unwittingly following technical analysis procedures without knowing it (I've only learned the basics of TA in the last two months).

 

[andycan]

depends what your definition of technical analysis is
TA can and does include fundamentals
an economist looks at a macro situation puts it on a graph and sees whether its in an uptrend or a down trend
or may make a statistical reference either way he is weighing the new information with the old
if you are referring to standard oscillators and indicators then i personally dont think much of them
you trades the ftse because when the news says panic you are looking for a buy
you have just used a form of analysis

 

[damianoakley]

Hi Neil,

Technical Analysis is a trading tool - it is not a complete strategy. Technical Analysis usually describes the technical indicators that you can apply to a price chart. These indicators can prove useful in helping traders to determine the direction of a market, but you cannot be black and white about Technical Analysis because much of it is subjective. If you have a belief that a market might move in a certain direction, if you searched long enough, you could find some technical indicator somewhere that would back up your belief. That's why technical analysis is not black and white. It is not a case of finding Technical Analysis that "works". There is no, as you put it, "correct way to implement technical analysis" because there are just so many variations to the indicators that you could apply to a chart.

A prime example of just how subjective Technical Analysis can be is in the very last part of your post. You say that from a TA point of view you were "buying on the pullback of an upward trend". Now you could ask yourself: How did you come to that conclusion? How did you measure that trend? - was it using a moving average? if it was, then what sort of moving average was it? was it a 200-day SMA or a 50-day EMA? And as for measuring when to re-enter with the trend, you could have used Stochastics or a 20-day price break-out strategy, or something else?

You see my point - there are so many TA variations that you could use - part of the battle is finding a method of TA that you believe in. And that is why Technical Analysis tends to be different for everybody.


Hope all that helps,

Thanks

Damian

 

[TWI]

TA will not work without money management but there again nor will any other method.