Monday, May 12, 2014

Technical Analysis Doesn't Work... But I use it anyway.

Study after study has demonstrated that technical analysis doesn't really work. For example, an October 2009 study by New Zealand's Massey University tested more than 5,000 technical analysis strategies in 49 different countries. The result? Not one strategy generated returns that aren't predicted by chance.   

Sure we can point to one stock that had the perfect text book breakout.  But then if we think back over our trades we will see just as many failed breakouts.  KBH is one that I had.   In KBH we had a nice breakout over $19.50, a continuation the next day up over $20.70  and then total failure past the point of breakout... past the consolidation area.  

As studies show, a "good chart" is just as likely to make for a losing trade as a "bad chart."    I think as a whole, it tends to make traders lazy.  It seems like these days everyone is an expert at technical analysis.  Yet very few know how to read a balance sheet and even fewer constantly make money trading.

In one of the more interesting studies that I've seen, it was demonstrated that the buy strategy  matters far less than the sell strategy.  Using coin flips to enter a trade, you could still make money with well defined exits. This is interesting because there are hundreds of websites recommending stocks to buy and focusing on buy strategies.  Yet it is the sell strategy that  generates the returns.  Notably,  famed commodities trader Peter Brandt estimated that his gains were from just a few trades a year:

  • Expect the bottom line over an extended time frame to be represented by only 10% of all trades. The other 90% of trades will be washes.
 His gains can be attributed to risk management as he avoided the large losses.  His record of successes  is  reduced to the maxim "cut your losses short and let your winners run."  


Although I'm of the opinion that Technical Analysis does not work (and I find it comical when people say that a stock has to break a precise penny amount to breakout) I do find it helpful in a following regards:

1. Am I buying value or am I chasing.

I prefer to buy pre-breakout and take my chances that the stock eventually will breakout to the upside.  Given that buying breakouts provides  no more statistically significant profit probability than any other movement, I would rather buy in an area where others have found value, I.e. a consolidation area. This gives me room for error.  I also like to sell a portion of the position off into any breakout, which hedges me against a false breakout and exposes me to less risk.  The downside of such an approach is that I may be in a stock for an extended period while it is in sideways range.  If it does begin an up move, this works to my benefit for tax reasons if I can hold in excess of a year my tax rate is significantly reduced.

2. Am I buying strength or weakness?

All things equal, stocks that have performed are more likely to continue to perform. I'd would rather being in a stock that is going up than down. I would rather buy stocks outperforming the market  on a temporary weakness than attempting to exploit an over-reaction. Reversion strategies such gap filling work well until the one time they don't... and the losses are massive when those strategies don't work.    

On a trending stock, I would prefer to buy a pull back to the middle of the trending range (or short the inverse).  To trade reversals, I want to see an extended bottom, which tells me others are finding value in the range. A sharp stab downwards, is a falling knife and the risk is extreme of both more down side or a quick upside. That becomes just gambling that does not permit adequate risk management.

3. Am I managing my risk?

One of the best pieces of advice that I have seen regarding risk management is that your stop should be placed at the level that disproves your theory. You then position size accordingly.  

If I think a stock is going to breakout to the upside I would place a stop at the level that disproves my hypothesis. In my opinion, its fine if a breakout fails and gets sucked back into consolidation area where people have been supporting the stock.  I should be in already with room to spare, even if this happens I will be in a decent position. It's the break to the downside of the consolidation zone that cause me to exit. 

For example, In my XCO trade I was in in the $5.80s. This had the possibility of presenting a multi-month bottom, which can produce huge returns.  For that reason, I didn't sell after a nice pop to 6.60. Had I looked for a shorter term move, I would have.  I also would have taken more size on the trade but I digress.  After a month of consolidation between $5.75 and $6.25, (an area where traders were finding value) it broke hard to the downside. My theory that a multi-month move to the upside was beginning was disproven and I took my loss.

 I've seen too many people on Stock Twits, or the like, who attempt to justify a losing trade (and their  refusal to take a loss) based on TA. This practices will destroy your account.  Your exit needs to be known before you enter.


Despite this criticism, technical analysis has its place. Stocks that begin big moves have similar looks to them before they start.  For that narrow reason, technical analysis can help weed through the stock universe to find candidates that have "that look to them.  Given enough chances some will hit.  Peter Brandt's approach results from him being in the commodities than are beginning runs,  not taking big loses. Combined with proper risk management procedures you can avoid the risk of big losses.  Thus, keeping you in the game giving you more chances to be in the stocks that run.  It's that simple... cut losses short, and let winners run.

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