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CATEGORY Technical analysis

Four Technical Trading Myths Dispelled



January 05, 2017

Ever since traders said they could tell the direction of a stock based on a bunch of lines on a chart, technical analysis has been ridiculed.

Academics swear it’s useless, akin to reading the tealeaves.

Others say its pure pseudo-science with no validity, hell bent on predicting prices moves based on repeatable patterns. Instead, many argue for fundamental analysis in an attempt to buy when a company’s price poorly values its earnings potential.

Warren Buffett, Peter Lynch, and Benjamin Graham are great fundamental investors.

Aside from being wildly successful investors, they only use fundamental analysis to dig up a market-beating stock. In a world of charts, trend lines, and candlesticks, they have relied entirely on fundamental analysis to earn their famous fortunes.

In fact, their disdain of this is so complete that Buffett once remarked, "I realized technical analysis didn't work when I turned the charts upside down and didn't get a different answer."

Meanwhile, Lynch observed, "Charts are great for predicting the past."

And Graham before them who famously said, "In the short term the market is a voting machine, but in the long run it is a weighing machine."

Instead of focusing on solely on market momentum, all three simply focused on finding long-term value. And over time, it made all of them very wealthy.

But what the critics don’t understand is that technical analysis paints a clear picture of fear and greed, optimism and pessimism as dictated by thousands of traders.

In fact, there are quite a few flaws in the arguments against technicians.

No. 1 – Past Prices can’t predict the future

There’s no such thing as a crystal ball when it comes to trading.

However, when we find similar patterns repeat themselves again and again, they become a bit more reliable to the tens of thousands to traders that rely on them.

For example, if we found that a stock has a tendency to hold support at specific prices over and over again, we can argue for strong support. Or, if a stock tends to die at prior points of resistance, we can argue a higher likelihood of failure at those same points… at least, until the trend is broken.

For example, every time Facebook falls to $115, it has a tendency to hold that price and eventually move higher.

No. 2 – It’s only good for Short-Term Trading

That’s not true at all. In fact, we can plot charts going out years using the 50-day and 200-day moving averages, for example. For example, look at how well the IBB has held the 200-day for years before breaking down.

No. 3 – The Big Guys don’t Use Technical Analysis

That’s laughable.

Some of the most respected global investment banks and hedge funds make great use of technical analysis.

Countless hedge funds, traders, and banks rely on it, including Credit Suisse, which notes:, “At Credit Suisse, we combine classic charting techniques with the application of select statistical indicators applied to a range of bespoke Credit Suisse data indices, such as Global Risk Appetite and World Wealth. We focus particularly on applying technical analysis to highlight key macro themes, risk trades and cross-asset correlations.”

No. 4 – It has a Low Success Rate

It may not have 100% accuracy, but then again, neither does fundamental analysis.

If you’re a good technical analyst you can find success 75% to 80% of the time. But it’s only reliable if you follow the rules, follow the trends, confirm with multiple indicators, and pay close attention to what momentum is telling you.

For example, if I find that a stock hits the same support line five times, coupled with five indicators (Bollinger Bands, MACD, RSI, MFI and W%R) that tell me a trade is oversold, it’s likely to bounce. Why would I ignore that?

A study titled, “Market Efficiency and the Returns to Technical Analysis” found that profits from technical trading rules don’t exceed estimates of transaction costs.

Another one, titled “A Note on the Weak Form Efficiency on Capital Markets” applied technical trading, and again found that profits weren’t large enough to overcome transaction costs.

Both are laughable. In fact, using technical analysis alone with the IBB example above, we watched as an $80 ETF rocketed to $400.

 


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