In Defense of Technical Analysis

Tonight I jumped into a heated discussion on the Zecco community forums called "An Argument Against Trading." I understand the theoretical basis for technical analysis, which underpins my trading, but I forget that others don't, and I forget that many view it as a kind of voodoo. Even many who employ it have no understanding of or curiosity for how it works.

Simply put, technical analysis is the study of human behavior in a market context. Academics will call it behavioral economics. Your classic stock chart is a representation of how groups of people have evaluated a particular good (in this case a financial instrument) over time. A chart therefore depicts a series of supply and demand data.

On the other hand, fundamental analysis is the study of the good itself. This is an example of classical economics, which assumes that humans are rational beings and therefore the human element may be abstracted out of the equation. Classical economics is flawed. The most important factors in the market are the market participants themselves, who have free will, who can do unpredictable things (yet for some reason they tend to do things in predictable ways — go figure). Who cares what it is that they're trading!

Here is an excerpt from my post on the forum:

I observe that markets correct 33-66% of any advance, and this is an observation that is true for any time frame, and for any market (stock) no matter how solid fundamentally. Why? Because the ultimate irreducible is the human element: prices are motivated by groups of humans making evaluations, from the millisecond level to the span of a generation. The fundamental flaw in fundamental analysis is the amount of emphasis placed on a merely ancillary entity: the good being evaluated. In fact the good in question is irrelevant - it could be securities, houses, tulips; it is the market participants' actions that are invariant from market to market. The field of economics has begun to recognize this mis-emphasis with the advent of behavioral economics....But I digress; point is a LTBH strategy will end up giving back 1/3 - 2/3 of high watermark gains, no matter the timeframe. And that is ridiculous.

Meanwhile, a skilled trader

• makes moves based upon empirical observations of raw supply and demand data
• holds that supply and demand follow repeated price patterns (trends)
• takes calculated risks based upon these observations, keeping losses to a fixed maximum per trade while allowing profits to grow to any amount (the concept of a sell-stop)
• thereby allowing profits to grow at a greater rate than losses

and, I might have added, keeping drawdowns minimal. Investors focus intently on percentage return, but the other important factor is the variability of those returns. For example, the return in the S&P for 2007 was 4%, which seems OK, not great; but does 4% in any way, shape or form capture this price action?


There's very little assurance that that +4% return wouldn't turn into a -4% return in a month — it's all over the place. That it finished at +4% instead of -4% is a fluke. On the other hand, here is a chart of my personal return for 2007:


So much less variability — notice the slow but steady growth in accumulated profit. An interesting thing happens when you compare my return to the S&P. Every time the S&P fell, so did my return; but whereas the S&P gave back at least 33% of each upward move, I did a much better job of protecting my gains. And that's despite having stepped into a landmine called Biogen IDEC mid-December. Protecting your gains is the primary goal of a good trading system. Full disclosure: I achieved this performance thanks in large part to trading with The Real Time Trader. By the way, if the chart of the S&P return resembles your return, then you need help. I urge you to develop a system that allows you to build profit steadily over time. You could try mine, or better yet take a look at Sites I Frequent on the right-hand side of this blog and get some perspectives from other traders. Confession time: here is a chart of my return for one typical year back when I was a long-term buy-and-hold (LTBH) investor:


A year's worth of hard work, dozens of discounted cash flow calculations — for less than nothing!