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The problem with technical analysis...

Apr. 29, 2011 9:37 AM ET
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Seeking Alpha Analyst Since 2011

I am retired from the health care industry and have all my funds in an IRA, so have to make the money there last until I die, and preferably a bit longer.

... is that it is such a crude tool, and as soon as we start making trading rules based on technical analysis we are likely to be heading for disaster sooner or later, because technical analysis indicators, by definition, are an aggregation of mixed data.

For example, looking at something like a 20-day moving average is meaningless unless we look at the whole gestalt and figure out what was happening on the macroeconomic level as well as what was happening to that individual stock in that time period. Was it making an earnings announcement or paying a dividend? Did it file any 10K information? Did it make a secondary stock offering?

If the stock is a small cap, did it appear to be under accumulation by a large buyer? Was there greater volume on certain days of the week?

It seems to me that all of those factors need to be considered or eliminated when we look at a 20-day moving average crossing a 50-day average or vice versa.

Similarly Bollinger bands are very useful for charting the standard deviation of a stock, but without knowing what black swan events have triggered breaches of the Bollinger bands in the past, and possibly in the future, they may not be all that relevant.

I'm not saying that technical analysis is useless, but it has to be used very carefully. My preference is for looking at each individual daily candlestick and trying to figure out what was going on that particular day, especially when there is a lot of movement. The Chaikin Money Flow Indicator set to a single period can be very handy when used to examine the money flow on each day. It is also useful to note the relationship between money flow and volatility on each day and at each price point.

Of course the counterargument would be that it is not necessary to know all these things, because the whole point of technical analysis is that it aggregates data and that all of these events mentioned produce known patterns on charts and in indicators.

But overall I increasingly find that looking at a summary of a number of indicators for each individual day and even for time periods within a day is a better guide for trading than just looking for buy or sell signals or patterns on technical charts, especially as these can often be recognized mechanically. In fact many brokers now provide software and scanners that will identify such opportunities for trading.

The trouble is that everyone else has the same information including market makers and others with the financial clout and opportunity to move markets where they want them--temporarily, at least.

Coming next: The great loophole that can make you money every day.

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