Why does technical analysis work on indices?

[richy96]

I know that sounds like an odd question but let me explain.

As I understand it, technical analysis is basically a self fulfilling prophesy.

Forgive me if I am wrong, but many many traders look at the same charts and see Support and Resistance levels, trend lines waiting to be broken, double tops, double bottoms, fibonacci levels, special cycles, patterns, moving averages, divergences etc and they all use those same levels (Admitedly in many different ways) to decide their entry and exit points.

So therefore price will bounce off a trend line or fibo level, broken support will become resistance etc simply because there are so many traders looking for those levels, they make it happen. I can't think of a better explanation for why Technical analysis works on Forex, shares etc.

If the above is a true explanatoin for why TA works then what has me puzzled is why it works on indices.

For example the value of the FTSE 100 is simply a sum or some such calculation of the value of the top 100 shares at any given moment. Now I can understand why technical analysis. would work for each of those shares individually for the reasons above, but in that case wouldn't the value of the index itself be chaotic - as it is made up of the TA applied to so many different shares, all of which behave in different ways at any given moment?

I hope I explained the question well enough to make sense.

Any thoughts anyone?

Rich

 

[barjon]

Rich

FTSE reflects what is happening to the FTSE futures which are directly tradeable and therefore subject to the trader activity that causes TA to "work" if it ever does. Whether TA "works" or not is a vexed question. To my mind it just highlights places where it is reasonable to make an assumption and trade it - cutting out quick if that assumption doesn't pan out and staying for a ride if it does.

 

[dbphoenix]

I know that sounds like an odd question but let me explain.

As I understand it, technical analysis is basically a self fulfilling prophesy.

Forgive me if I am wrong, but many many traders look at the same charts and see Support and Resistance levels, trend lines waiting to be broken, double tops, double bottoms, fibonacci levels, special cycles, patterns, moving averages, divergences etc and they all use those same levels (Admitedly in many different ways) to decide their entry and exit points.

So therefore price will bounce off a trend line or fibo level, broken support will become resistance etc simply because there are so many traders looking for those levels, they make it happen. I can't think of a better explanation for why Technical analysis works on Forex, shares etc.

If the above is a true explanatoin for why TA works then what has me puzzled is why it works on indices.

For example the value of the FTSE 100 is simply a sum or some such calculation of the value of the top 100 shares at any given moment. Now I can understand why technical analysis. would work for each of those shares individually for the reasons above, but in that case wouldn't the value of the index itself be chaotic - as it is made up of the TA applied to so many different shares, all of which behave in different ways at any given moment?

I hope I explained the question well enough to make sense.

Any thoughts anyone?

Rich

Technical analysis is not a self-fulfilling prophecy. Many if not most small retail traders guess that price will do such and such. The rest hypothesize that price will do such and such based on the testing they've done. Whether it does or doesn't do what is guessed or hypothesized is unknowable, but, if the probability for a given directional movement is acceptable over a series of trades, then the risk become worth taking.

As for all the "tools" that SRTs use to make their guesses better, these operations can't be self-fulfilling because not everyone is looking at the same charts using the same intervals using the same timeframes using the same tools using the same settings and managing the trades the same way with the same risk tolerances. Therefore, virtually all the activities in which the SRTs engage effectively cancel each other out and become relatively meaningless, which is the chief reason why so many fail.

Big Money (institutions, etc) look for value. When they find it, they buy. When whatever they're looking at becomes overvalued, they sell. These value levels are relatively easy to find. Traders who understand how BM trades and what it looks for will in a sense go along for the ride. Those who use indicators and patterns and so forth may luck onto a move initiated by BM, but this is purely coincidental. Positing therefore that technical analysis of the indicator/pattern sort "works" is unjustified and insupportable.

I've posted this elsewhere, but it doesn't hurt to repost it now and then:

A fundamental misunderstanding of how "indicators" are calculated and what they're supposed to do can lead to all sorts of off-task behavior. We think we see the indicators indicating something, or not, and believe we have made an important discovery. We then devote our efforts to improving the hit rate and the probability of whatever it is we think the indicator is indicating when our efforts ought to be focused on determining whether or not the indicator is actually indicating what we think it's indicating. In most if not all cases, it isn't.

Consider the virgin being tossed into the volcano: sometimes it results in a great crop, sometimes it doesn't. Maybe tossing her in earlier or later will change the probability of a healthy crop. Maybe two virgins are better than one. Maybe six. Maybe tall virgins are more effective than short ones. And surely age is important. But does the robustness of the crop really have anything to do with tossing the virgin into the volcano in the first place?

The money under the pillow is not evidence of the existence of the tooth fairy, and spring will arrive regardless of whether the virgin is tossed into the volcano or not.

 

[richy96]

Rich

FTSE reflects what is happening to the FTSE futures which are directly tradeable and therefore subject to the trader activity that causes TA to "work" if it ever does. Whether TA "works" or not is a vexed question. To my mind it just highlights places where it is reasonable to make an assumption and trade it - cutting out quick if that assumption doesn't pan out and staying for a ride if it does.

Yeah I know when I trade FTSE CFDs I am trading futures which are dependant on 'direct trader activity'. I didnt' at first know that until why I wondered the price I was seeing for the FTSE was not the same one on Sky news.

Having looked at the 'real FTSE' charts though, it appears trend lines still exist there.
@dbphoenix - I would like to discuss your proposition further but have to go out now so it will have to wait until tomorrow

Rich

 

[timsk]

. . . As for all the "tools" that SRTs use to make their guesses better . . .]

Hi dbp,
Just for clarification: SRT = Self taught Retail Trader?
Tim.

 

[timsk]

I know that sounds like an odd question but let me explain.

. . .I hope I explained the question well enough to make sense.

Hi richy,
It's not an odd question at all and your explanation makes perfect sense.

Just to reinforce Jon's (barjon) point, an understanding of the relationship between the cash index and the futures will go some way towards answering your question. So, if you've not yet seen it, this 'Sticky' might be worth a read: Essentials Of 'Indices'.

To pick up on dbp's point about TA and it's associated paraphernalia (Fib' levels, Gann cycles and Elliot Waves etc.), being sceptical about it all is no bad thing - assuming you are that is! On that note, this Sticky may also be of interest: Essentials Of Technical Analysis
Tim.

 

[dbphoenix]

Hi dbp,
Just for clarification: SRT = Self taught Retail Trader?
Tim.

Small Retail Trader.

 

[richy96]

Thanks Tim, I will read those and congitate.

@dbphoenix
Didn't get time to post this reply as I was busy last night, I do some DJing as another income stream and of course it was halloween.

OK so from your reply - are you basically saying in your opinion that Technical Analysis (indicators patterns and levels et al) are useless and or meaningless?

I have wondered sometimes about the usefulness or otherwise of some of them - for example how MACD is supposed to show volume. I mean I understand how it is calculated, I usually have it on my charts, but have not got my head around how the difference between two moving averages has any relationship to the actual volume of orders in Forex. Unless someone who had access to the actual volumes also designed MACD and compared them to prove that the two indicate essentially the same thing.

But are you also saying all aspects Technical Analysis eg. support and resistance levels, fibo levels and trend lines are also meaningless or useless (ar at least as much use as tossing virgins into a volcano)? I can't understand that logic if you were.

I can draw a trend line today once I see price bounce two or three times from a certain area, and then let's say a day or week later price will hit exactly the same trend line and it will almost cetainly react to it (whether it bounces, or breaks and retests, or goes 'flat' at that level) it seems obvious to me that the trend line I drew a few days ago is 'real' otherwise price would not react in any way at all. Surely therefore the reaction of price to the trend line proves it is not imaginary.

Same I guess when price hits a MA, it generally 'reacts' in some noticeable way, doesn't just 'ignore' it like it isn't there.

And if we accept the trend line is 'real' and can affect market price movement then what makes it real unless it is a self filfilling prophesy as I hypothesised.

Or are you saying all this analysis is imaginary or meaningless anyway, so one may as well pick balls from a bag (one marked with a currency pair and the other marked buy or sell) and use that as a basis for entering trades instead.

Or if that fails then throw a virgin into a volcano and enter a long or short depending on which way up she hits the lava? I hope not. Virgins are harder to find round here than profits!

Rich

 

[richy96]

Ahhh I see now

Thanks for the links Tim - didn't find the one about indices particularly useful to me (though intersting) but I loved the one about Technical Analysis - lots of points of view I had not come across before that inspire some deeper thinking.

From there I found the link to the dblphoenix 'if you can draw a straight line .pdf' and now realise you were not trying to tell me that TA was about as usefull as tossing virgins into a volcano! :cheesy:

I've not had chance to study the pdf yet but I certainly will over the next couple days.

Rich

 

[gerryg]

I know that sounds like an odd question but let me explain.

As I understand it, technical analysis is basically a self fulfilling prophesy.

Forgive me if I am wrong, but many many traders look at the same charts and see Support and Resistance levels, trend lines waiting to be broken, double tops, double bottoms, fibonacci levels, special cycles, patterns, moving averages, divergences etc and they all use those same levels (Admitedly in many different ways) to decide their entry and exit points.

So therefore price will bounce off a trend line or fibo level, broken support will become resistance etc simply because there are so many traders looking for those levels, they make it happen. I can't think of a better explanation for why Technical analysis works on Forex, shares etc.

If the above is a true explanatoin for why TA works then what has me puzzled is why it works on indices.

For example the value of the FTSE 100 is simply a sum or some such calculation of the value of the top 100 shares at any given moment. Now I can understand why technical analysis. would work for each of those shares individually for the reasons above, but in that case wouldn't the value of the index itself be chaotic - as it is made up of the TA applied to so many different shares, all of which behave in different ways at any given moment?

I hope I explained the question well enough to make sense.

Any thoughts anyone?

Rich

You got this point right. I was also thinking about this question a lot and came to conclusion that traders make those levels work but don't because they think about that. There are some other concepts that make those levels work especially S/R because they are subject to basic rules of supply and demand

 

[dbphoenix]

OK so from your reply - are you basically saying in your opinion that Technical Analysis (indicators patterns and levels et al) are useless and or meaningless?

No. You're equating "technical analysis" with indicators and patterns. Technical analysis is the analysis of price movement. Indicators and patterns are allegedly tools to aid in that analysis. But without a thorough understanding of price movement the tools are useless. If it were otherwise, the success rate would be far greater than it is.

I have wondered sometimes about the usefulness or otherwise of some of them - for example how MACD is supposed to show volume. I mean I understand how it is calculated, I usually have it on my charts, but have not got my head around how the difference between two moving averages has any relationship to the actual volume of orders in Forex. Unless someone who had access to the actual volumes also designed MACD and compared them to prove that the two indicate essentially the same thing.

The MACD has nothing to do with volume.

But are you also saying all aspects Technical Analysis eg. support and resistance levels, fibo levels and trend lines are also meaningless or useless (ar at least as much use as tossing virgins into a volcano)? I can't understand that logic if you were.

S&R levels may or may not be useful depending on whether or not the trader is drawing them correctly. Nearly all struggling traders draw them incorrectly. Therefore their levels are useless. Yes, Fib levels are useless. Trendlines may or may not be useless depending on how and where they are drawn. If drawn correctly, they can be useful. If not, they are of no more use than any other line.

I can draw a trend line today once I see price bounce two or three times from a certain area, and then let's say a day or week later price will hit exactly the same trend line and it will almost cetainly react to it (whether it bounces, or breaks and retests, or goes 'flat' at that level) it seems obvious to me that the trend line I drew a few days ago is 'real' otherwise price would not react in any way at all. Surely therefore the reaction of price to the trend line proves it is not imaginary.

The trendline is in your head, not in the market. As the market can't know what's in your head, it couldn't care less about your trendline. What is in the market and therefore a catalyst for reaction are the swing points that are used to draw the trendline, not the trendline itself.

Same I guess when price hits a MA, it generally 'reacts' in some noticeable way, doesn't just 'ignore' it like it isn't there.

An illusion.

And if we accept the trend line is 'real' and can affect market price movement then what makes it real unless it is a self filfilling prophesy as I hypothesised.

See above.

Or are you saying all this analysis is imaginary or meaningless anyway, so one may as well pick balls from a bag (one marked with a currency pair and the other marked buy or sell) and use that as a basis for entering trades instead.

There are other choices, the chief among them is understanding price movement. This need not involve drawing lines of any sort. Or "patterns". Or plotting indicators. One needs primarily to understand the difference between up and down and those transition points and levels where one becomes the other.

If you want to pursue this, I suggest you read my Trading Price thread (link provided in my signature.

 

[sminicooper]

dbphoenix's post at #11 really is T2W at its best. Good on you db.

 

[richy96]

If you want to pursue this, I suggest you read my Trading Price thread (link provided in my signature.

Of course I will - why would I not want to pursue it?



Reading.........

 

[richy96]

The trendline is in your head, not in the market. As the market can't know what's in your head, it couldn't care less about your trendline. What is in the market and therefore a catalyst for reaction are the swing points that are used to draw the trendline, not the trendline itself.

Oh and also - I'm not at all certain what is the difference between the 'swing points' you mention and the resulting trend line plotted from them (maybe when I read the above link you mentioned it will clarify this).......

But I have proved to myself over and over again I can draw a line on a chart that the market price will have a decisive reaction to hours or days later. I can't necessarily predict what the actual reaction will be (yet?) though i do try to look for entry points, but price does almost always react noticeably at that pre-drawn trend line

So from this observation is it reasonable to take some satisfaction from the fact I am learning to draw them correctly?

And from what you say... that would be a very good ability to aquire?

Rich

 

[Needless Promo]

Profit taking

I know that sounds like an odd question but let me explain.

As I understand it, technical analysis is basically a self fulfilling prophesy.

Forgive me if I am wrong, but many many traders look at the same charts and see Support and Resistance levels, trend lines waiting to be broken, double tops, double bottoms, fibonacci levels, special cycles, patterns, moving averages, divergences etc and they all use those same levels (Admitedly in many different ways) to decide their entry and exit points.

So therefore price will bounce off a trend line or fibo level, broken support will become resistance etc simply because there are so many traders looking for those levels, they make it happen. I can't think of a better explanation for why Technical analysis works on Forex, shares etc.

If the above is a true explanatoin for why TA works then what has me puzzled is why it works on indices.

For example the value of the FTSE 100 is simply a sum or some such calculation of the value of the top 100 shares at any given moment. Now I can understand why technical analysis. would work for each of those shares individually for the reasons above, but in that case wouldn't the value of the index itself be chaotic - as it is made up of the TA applied to so many different shares, all of which behave in different ways at any given moment?

I hope I explained the question well enough to make sense.

Any thoughts anyone?

Rich

Profit taking is the main predictor of indexes and forex. Profit incentive is what is predictable.

 

[dbphoenix]

Oh and also - I'm not at all certain what is the difference between the 'swing points' you mention and the resulting trend line plotted from them (maybe when I read the above link you mentioned it will clarify this).......

But I have proved to myself over and over again I can draw a line on a chart that the market price will have a decisive reaction to hours or days later. I can't necessarily predict what the actual reaction will be (yet?) though i do try to look for entry points, but price does almost always react noticeably at that pre-drawn trend line

So from this observation is it reasonable to take some satisfaction from the fact I am learning to draw them correctly?

And from what you say... that would be a very good ability to aquire?

Rich

Price movement is in the market. Whatever lines or patterns you may draw or indicators you may apply are in your head. It is illogical to believe that millions of traders all over the world are going to reverse price at something you've drawn and which they know nothing about. Any movement at your line will be purely coincidental. This is not to say that your lines can't be useful, but you are making illogical and incorrect assumptions about the information they provide.

There are several cognitive biases going on here, chief among them Confirmation Bias. Guard against them.

 

[timsk]

. . .This is not to say that your lines can't be useful, but you are making illogical and incorrect assumptions about the information they provide.

Hi Rich,
It's worth pointing out, I think, that believing there's something 'meaningful' about price appearing to react to a line you've drawn or an indicator etc. is a very common reaction and one that many traders cling to throughout their trading lives. So, you're far from alone in this: it's not a newbie error. Indeed, I can think of more than one esteemed member (and experienced trader) of this forum who will argue till they're blue in the face that price 'bounced off his MA' and that his 'trendline provided resistance/support' etc.

I hope dbp will agree with me when I say it doesn't much matter what you believe about the markets and how they function and whether or not you make illogical and incorrect assumptions if (big if) your PnL is in the black and growing. If it's not, then questioning your thoughts on this issue could be well worth exploring.
Tim.

 

[richy96]

@tim, dbphoenix

No worries, I'm not thinking you guys are 'having a go at me' if that is what was in your thoughts.

OK, I did think after posting that 'the price bounced of a line that I drew' is the wrong way of putting it.

Of course I can understand the fact that price reversals would occur whether I drew that line or not. Like you say the market has no idea that I drew that line, and even if it did, why would it care?

This is a bit like arguing whether a falling tree would make a noise if no one was there to hear it, isn't it?

Maybe what I should have said is I do seem to have developed a knack of drawing lines, that regularly predict future points at which price is going to change it's direction or momentum. Not always of course... but often enough to be significant.

Whether the price 'bounced of a line I drew' or the line 'helped me predict future price movements', doesn't it just amount to the same effect?

So whichever you want to call it (are we just being pedantic? does it matter?) I think that must be a worthwhile skill to have learned. To me anyway.

Rich

 

[dbphoenix]

Whether the price 'bounced of a line I drew' or the line 'helped me predict future price movements', doesn't it just amount to the same effect?

Perhaps, but it is nonetheless irrelevant. Every trader in the world knows what yesterday's high and low were in the Dow, the S&P, the Dax, and so on. Nobody can see your line. Therefore what everyone knows and can see is more likely to be a catalyst for price movement than something that they can't see and know nothing about.

The markets may not always be rational, but they are always logical, at least to those who trade to make money.

 

[Fugazsy]

No. You're equating "technical analysis" with indicators and patterns. Technical analysis is the analysis of price movement. Indicators and patterns are allegedly tools to aid in that analysis. But without a thorough understanding of price movement the tools are useless. If it were otherwise, the success rate would be far greater than it is.



The MACD has nothing to do with volume.



S&R levels may or may not be useful depending on whether or not the trader is drawing them correctly. Nearly all struggling traders draw them incorrectly. Therefore their levels are useless. Yes, Fib levels are useless. Trendlines may or may not be useless depending on how and where they are drawn. If drawn correctly, they can be useful. If not, they are of no more use than any other line.



The trendline is in your head, not in the market. As the market can't know what's in your head, it couldn't care less about your trendline. What is in the market and therefore a catalyst for reaction are the swing points that are used to draw the trendline, not the trendline itself.



An illusion.



See above.



There are other choices, the chief among them is understanding price movement. This need not involve drawing lines of any sort. Or "patterns". Or plotting indicators. One needs primarily to understand the difference between up and down and those transition points and levels where one becomes the other.

If you want to pursue this, I suggest you read my Trading Price thread (link provided in my signature.

Good read, post 7 in particular.