Why Technical Analysis Won't Make You Rich

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by: Andrew McElroy

Summary

Some people love technical analysis, some people loathe it.

If technical analysis works so well, why doesn't everyone use it and why isn't everyone rich?

You won't ask that question again if you read this article.

Most of my articles use technical analysis, and most of my articles get a few comments at the end about how technical analysis doesn't work. I try not to get drawn into debates on the subject. Someone who feels impelled to leave comments about a method they don't agree with is unlikely to change their mind because of anything I say. Beliefs are pretty strong.

But what often surprises me is how some people perceive technical analysis. I often hear the question, 'if technical analysis works so well, why doesn't everyone use it and why isn't everyone rich'?

And it's a reasonable question. At least, from someone who doesn't understand technical analysis.

I could teach my eight-year old son how to spot head and shoulders patterns, draw trendlines and spot where the 200dma is on a chart. Why won't he be a billionaire by the time he's sixteen? That can be answered with one word; 'context'.

Context Is Key

Reading a few books and learning a few patterns will equip you with a handful of tools. Let's compare them to say, a hammer and a chisel. Fine if you are making a table, but not much use when you try and fix a computer. The market is a thousand different things from one day to the next and the real skill lies in identifying the type of market we are in and what tools to use.

That's not to say your analysis has to be complicated. I've seen successful traders use quite simple techniques, but the point is they know when to use them and know when to stay out. In a strongly trending market, you can simply use a trendline or short-term moving average as an inflection point to keep you in the trend. This can lead to huge profits. Use the same method in a range and you'll probably lose your shirt.

Losing your shirt is just part of the learning curve with any method. You may hit a few winners, but eventually a loss will come which makes you re-think your approach. This is where many skip to the next technique or simply give up.

And this is precisely where many get it wrong. It's natural to blame or dismiss the technique you are using. If you traded the 200dma three times in a row and had three losers, it's reasonable to think it simply doesn't work. You'd at least conclude it is too unreliable to successfully trade.

Let's look at a real life example of the S&P 500 (SPY):

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The six blue circles highlight when the 200dma had little or no effect. If you expected price to reverse from here you'd likely have taken six losses. After these six losses would you have bought the red circles? Even after Brexit? Even right before the election? Probably not.

But what if you'd done a lot of background research and knew the context wasn't right to trade the blue circles? Easy to say in hindsight, but there are a variety of methods which could have helped you. Some of these can be learned from books, but the best traders develop their own mixture of techniques and signals.

A Process

I'm not sure if I fit in the 'best traders' category, but I'll give you an example of my process which I have developed from books, mentors, and most of all experience.

The point here is to show two things.

Firstly, there is a set process which blends various techniques and tries to set context. I don't just pull up a chart and start drawing on it. Anyone can join two peaks together and draw a trendline, but to get good at anything requires years of hard work and study.

Secondly, my process is developed by me for me. If anyone else tried to use it, they'd likely lose money. I can't package and re-sell my system as a get rich quick scheme.

I take a top down approach and use the same approach for monthly, weekly and daily charts. I even analyze yearly charts, which probably sounds like overkill, but you only have to do it on the first day of the year and take a note of anything important.

I used yearly and quarterly charts to conclude 10-Year T-Bond Buyers Are Exhausted back in June. They can and do work.

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I maintain spreadsheets for the main markets I track. Below shows my weekly preparation for the S&P 500.

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There's a lot of jargon in there, but it illustrates a few things. The yellow section sets context by thinking about news and drivers, sentiment, breadth and seasonality. The orange section is for technical analysis. On the right side, I think about likely scenarios for the week.

It's not all 'squiggly lines and joining dots'.

So Does It Work?

I could cherry-pick a lot of trades to show technical analysis works well, but readers could also find a few of my articles where it went badly wrong. Neither would conclude once and for all if it worked or not.

Certainly, there are trades and calls you can make with technical analysis which you would struggle to if you only followed fundamentals. Here's a cherry-picked trade from my September article on indices with the update to the right.

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Who'd have thought Trump and the election would have the same effect on the Nikkei as the BoJ's easing announcement in October '14? Actually I had no idea what the catalysts would be, but my process did figure out the likely price path.

Again, this proves very little. I get some right, I get some wrong; everyone does. And really I'm not trying to prove anything here.

Hopefully, with a little more understanding of what technical analysis actually involves, people can make up their own minds.

Conclusions

I've heard it said it takes 10,000 hours to master something. Technical analysis is no different. It can't be broken down into three easy-to-follow webinars guaranteed to make you rich any more than fundamental analysis can.

Investors must make up their own minds if technical analysis is useful to them and their investment style. Hopefully, this decision isn't based on a few dismissive sentences in the comments section, or a bad call someone made sometime. Context is key, not only in technical analysis, but also in your decision.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.