Breaking with Tradition – Why I Don’t Use Technical Analysis: Part 1

Breaking with Tradition – Why I Don’t Use Technical Analysis: Part 1

My goal here is not only to provide knowledge but also to dispel a myth, the myth that markets are predictive. They are not. They are probabilistic. My trading methodology revolves around defining and assessing those probabilities based on a stock’s past behavior and the distribution of that behavior.

On the one hand, quantitative analysis is defined as a method of evaluating securities by analyzing statistics generated by market activity, such as past prices and trading volume. Technical analysis (TA), on the other hand, uses charts and other tools to identify patterns that can suggest future activity. A security’s intrinsic value is of no interest.

Technical Analytis Graphic

To put it simply, let’s watch a man walk down a city street. If he turns left three times in a row, simple TA suggests that when he gets to the next corner, he will again turn left.

Then again, he might turn right.

As such, there are limitations to a positivist approach (one that uses the scientific method) to trading. Knowing this limitation dispels any notion of finding a magic formula or universal cycle to describe the market’s future behavior. That doesn’t make technical analysis worthless; it is simply not foolproof. Instead, we can use it to build tools that will, using simple arithmetic, help you make educated guesses with a known probability of occurring and adjust your investment strategy.

With that in mind, if you’ve ever seen an advertisement for a brokerage firm, you have seen them emphasize their trading tools: “Advanced charting tools that will help you trade like a professional,” or some such nonsense. Most professionals don’t trade. Most are not allowed to because of securities regulations against owning any stock they recommend to you. This creates an emotional disconnect between them and their recommendations. Without skin in the game, how can they feel your pain that results from their bad call?

Selling is harder than buying. So if they aren’t selling you trading expertise what are they selling?

They are selling the illusion that you can learn to beat the market with their software and its myriad of tools. They are not selling you anything unique (90 percent of the tools are available free on the Web) except maybe a user interface that will be overwhelming to any novice trader, and therefore utterly useless.

Over the centuries, back as far as ancient China’s rice markets, people have been analyzing how price, volume, and time interact to help guide their financial decisions. Whether they settled on using trend lines or chicken entrails, Elliott waves or the distribution of tea leaves, all of these consecutively and/or concurrently, their approaches were designed to help them predict the future. But, as I will argue later, predicting the market is a fool’s errand.