Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Technical Analysis that Works

 

 
"You see I can predict this stock went down!"

 

I've read a great deal on technical analysis and spent a great deal more time testing various indicators, programs, backtesting, and attending seminars on the subject.  At first I thought I would write a piece with a top down view and summarize the major indicators in use today.  I've hesitated and even anguished over doing that for a couple of reasons:  But first let's set the discussion by quoting Wikipedia's succinct definition:

"Technical analysis is a financial term used to denote a security analysis discipline for forecasting the direction of prices through the study of past market data, primarily price and volume.[1] Behavioral economics and quantitative analysis incorporate technical analysis, which being an aspect of active management stands in contradiction to much of modern portfolio theory. The efficacy of technical analysis is disputed by efficient-market hypothesis since stock market prices are essentially unpredictable."

I decided against writing a summary of technical analysis.  First of all-others have already done it.  And far better than I could.   Check out John Murphy's Technical Analysis of the Financial Markets: A Comprehensive Guide to Trading Methods and Applications.  TradeStation's own dictionary of technical analysis technical indicators is an incredible online help platform that provides a brief explanation of each indicator. It doesn't go into the formulas that calculate them but provides illustrations of how they look and work in their particular platform.    One of the true marvels of computing is that complex math formulas can review years of daily data of the high, low, close prices of stocks and render instant plots of whatever you can dream of.  This was one of the first incredible usages of personal computers probably right behind spreadsheets, word processors, and data bases.  But the bigger question is does technical analysis work?

Technical Analysis is Always Right until its Wrong

Does it predict future price movement?  Does technical analysis work? You would think that a discipline so heavily dependent on math and computers would have a simple answer to this question.  For several months I routinely and religiously ran a program that optimized dozens of technical indicators against the universe of S&P 500 stocks.  I was trying to determine which indicators tracked better.  Do some technical indicators work better than others?  I think most technicians would say yes without hesitation.  But if you believe that,  rephrasing the question is another way of asking if technical analysis works at all?  After all if some indicators dont' work better than others, perhaps none of them work at all.  If some indicators can predict future price movement better than others, then technical analysis works, right?

Not exactly.

So for the sake of argument, let's say that some indicators work better than others.  If you believe that then there are lots of shelf software out there that can scan historic price action, backtest an indicator, and provide you with comparison reports. I know of only one though that can backtest dozens of indicators against a common stock or index.   For example, I know Metasoft can do that.  I used it for quite some time, religiously running the entire S&P 500 against their universe of technical indicators and many third-party add-ons.  Astoundingly enough many stocks showed reliable patterns. Some indicators DID work better than others.  There was no doubt about it.  It was quantifiable, repeatable, and visible right in front of your face.

But really what does that mean?  As I found out the hard way, just because an indicator worked well for some period of time, there was no assurance that it would continue to work well.  If you are using raw computer power to find patterns, you will.  There is no doubt about that.  Life is full of patterns.  But I found no real evidence that running Metastock's indicators would work in the future.  Some indicators worked better than others on certain stocks until they didn't.  My proof was my money line.  It wasn't growing.   If you could go back in the past and buy or sell securities, I would be all over it but you can't. You can only buy or sell now or sometime in the future. When someone comes up with a future testing solution, I'll listen. I don't buy the premise that backtesting is any kind of reliable indicator of the accuracy of a technical indicator or strategy for the future.

A broken clock is right twice per day and we all know that's worthless.   But I do believe completely in technical analysis.  It's just that most of the indicators are worthless in my opinion.    So instead I've come up with a preferable solution.  I'm only going to talk about the ones that  either have some predictive ability or provide some trading advantage.  The ones that work.

Next - Divergence My Favorite Technical Indicator