- Pitfalls of Technical Analysis
- Why Technical Analysis is not a magic bullet
- Make more money by asking the right questions
- Always check your assumptions
Pitfalls of Technical Analysis
Technical analysis has a certain ring to it.
From the outside, it can seem like technical traders use mathematics to work magic and make a system that wins trades all the time. There is math involved, and to those of us not familiar with the math, it can seem like magic… or worse, a magic bullet.
The thing is, technical analysis is not a one-stop solution to your trading woes.
I would know. There was a time when I was losing consecutive trades, and I kept looking for a solution. Instead of asking my coach for advice and sticking to the method I learned, I kept looking for new technical tools and using them in place of the method (Sorry, Coach!) in the belief that more technical analysis was the solution.
The worst part? It would work! Even if it only worked for a short while, I would still believe in its predictive power. And in the same week, I would be making losses again, restarting the cycle.
I led myself down a rabbit hole and built horrible trading habits that then made it impossible for me to do any good analysis. The basis for all my trades would be wrong, and I would have a hard time explaining any of my trades during reviews.
Technical analysis is a powerful tool, and believing that it is the solution to your problems is tempting, but remember that it is only one step in your trading analysis.
Why Technical Analysis is not a Magic Bullet
Technical analysis has been in use for over 100 years. Libraries of research papers and books have been written on this topic. Is it based in scientific research? Definitely. Will the science solve all your trading problems? No.
Let’s get into the basics.
What is technical analysis? It’s the study of statistics and trends related to trading activity, such as price movements.
What do we do in technical analysis? We try to predict where price will move in the future, based on past price movements.
How does it work? That, my friends, is the key question.
Although technical analysis is rooted in math and science, it still relies on certain assumptions. All scientific research begins with questions and assumptions. It is impossible to create a mathematical model to include every data point that exists in the world.
That’s why technical analysis is based on the following assumptions, originating with Charles Dow’s research:
- The market is “efficient”
- All information is factored into the current price of any asset, so you’re always buying and selling at “fair market value”
- Prices move in trends
- History repeats itself
- Trends and patterns tend to repeat over time
Without these assumptions, it becomes impossible to create any model for a price analysis.
Side note: This is also why it’s a terrible idea to include all available indicators in your analysis. There will be too many outputs from the same data, each using different assumptions and solving different problems!
The next logical question: do the assumptions hold, all the time?
No. There have been cases where the prices of assets are far from “fair market value”, like during stock market crashes.
Why use technical analysis, then? That’s because technical analysis works, but not in isolation.
Make More Money by Asking the Right Questions
Technical analysis should be used alongside fundamental analysis. If you have both economic fundamentals and technical analysis supporting your trade idea, you’re much more likely to make money.
Want an example of this in action? Here’s one of mine.
When coronavirus fears took hold of the market, I looked for buying opportunities. Fundamentally, I believed the US economy was still strong. Technically, the S&P500 has been on a long uptrend.
At this point, I checked my assumptions.
- Would US economic fundamentals change overnight?
- It was hard to say, but I didn’t think so.
- Would the price trend change?
- Possibly, in the short to medium term.
- Was I buying at below market value?
- Probably, since there was a fear-induced market-wide sell-off.
- Were my fundamental and technical analyses aligned?
I reasoned that people would find ways to continue doing business despite the virus situation, and that businesses listed in the S&P500 are generally profitable, so investing in index funds would be a safe option.
To compensate for the risk of the trend changing – in which case my analysis would be wrong – I downsized my investment to reduce my risk. I got in at an advantageous price and my equities portfolio is still up by 15% for the year since March 2020!
The key to making sound technical analysis is to check your assumptions before you make your trade. Here are 3 examples:
- Will the fundamentals change?
- Will the price trend change?
- Are fundamentals and technical analysis aligned?
Try challenging yourself to give a true answer to these questions every time you plan a trade. You may be surprised by how your trade plan changes when you can’t give a good answer.
Check Your Assumptions, Always
Your assumptions will change your business problem and also change the method you use to answer them.
If you ask the wrong analysis questions or make wrong assumptions, you will correctly calculate the wrong metrics, and you will get a result that doesn’t meet your trading needs.
If you’re not sure whether you’re asking yourself the right questions, don’t fret.
Get yourself a good trading coach and consult them!
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