This Week’s Battle Plan

Yes, you read it correctly. Technical analysis does not work. First,
we learned last month from the 24-year old from the Wall Street
Journal who wears a tie to work every day, that “nobody,
absolutely nobody, is making money in this market.” And this week, in a
report published by CS First Boston, we learn (this time from from not
one, but from four guys who wear ties to work) that technical
analysis does not work. Two death blows within a 45-day period! And
what’s worse, because of this, it must mean that the people I so
respect in this industry must really not exist!. Phonies to the 10th
degree.

The Four Amigos

John Henry reportedly used nothing but technical analysis to amass his
fortune. A fortune that allowed him to buy the Boston Red Sox for over
$700 million. And now I learn that he couldn’t have possibly done it
from the methods he stated. At least not according to the conclusions
of this report. And other great men in this industry? Bill O’Neil, the
man thousands of successful momentum traders and money managers
emulate and so look up to? He too supposedly uses technical analysis.
He even has his own newspaper to prove it! But, again, according to
this report, it can’t be so. And, what about all those great traders
in Market
Wizards? And New
Market Wizards? Traders who have made millions and tens of
millions of dollars trading with technical analysis. They too
really could not possibly exist, according to this report. What did
this report examine? “Does Technical Analysis Work?” And its
conclusion? After costs, it does not. I quote, “We are concerned
with using technical strategy as a stand-alone investment strategy
owing to diminishing stability”

Whew! I know a lot of guys out there who have made a lot of money for
themselves and their families using technical analysis as the backbone
of their trading. I hope they don’t read this. They’ll be shattered!

Let’s See If There’s Hope For These
Millionaire Traders

Yes, maybe there’s still a glimmer of hope for these successful guys.
Let’s look at what extensive, ground-breaking analysis the four CSFB
gentleman, the Four Amigos, used to damn an entire industry.

First, they ran a whole seven tests (no, this is not a typo). And,
I’ll concede, the strategies they tested were earth shattering. Heck,
I wish I was so sophisticated to have thought of trading them first.
Strategies such as “Buy the market when the 9 day RSI is
below 30 and sell it short when it is above 70.” Bravo, gentleman!
How many nights did you sweat it out to come up with such genius? And,
it must have been weeks of non-stop thinking to come up with the
always-impressive MACD test. Buy the market when the MACD crosses into
a bullish trend and sell it when it crosses below. Wow! And, I know
you, too, are in awe of such strategic trading brilliance, so let’s move
on and we’ll be inspired by more genius at work. They ran one whole stochastics test. If one doesn’t work, then none will. And, I’m
glad they ran it, for now I can help Don Miller and his family out.
Don was in our office on Friday and traded live using stochastics.
But, according to this report, neither he, nor his bank account, is
smart enough to know that the “Four Amigos” at CSFB
said that stochastics don’t work. At least when it crosses below 30 as
an oversold indicator and above 70 as an overbought indicator.
Now, Don doesn’t trade it that way but it doesn’t matter. Stochastics
don’t work. And, neither do Bollinger Bands (after commission costs),
the Commodity Channel Index, Fibonacci retracements (see Kevin, I told
you!) nor Money Flow.

There you have it. An entire industry and all those success stories
killed in one seven-page report. In spite of all the documented
evidence, this industry, nor the success stories can possibly exist.
But, maybe, just maybe, Messrs. Yeung, Toikka, Patel and Kim might
want to go just a bit deeper. I’m sure coming up with those seven
tests exhausted these guys, so I’ll help them a bit.

Now, I don’t wear
a tie to work every day and I don’t work for CS First Boston, so I
want to go easy here. But, maybe they’d like to look at multiple
parameters. And, maybe they’d like to add a component that no
brokerage firm has ever heard of, known as “a stop”
to their testing, in order to lessen the runaway one-way hit. How
about time period exits? Would that help improve the results? What
about price exits? What about looking at the thousands and thousands
of combinations that can be done with multiple indicators? And, how do
these geniuses account for the fact that one of O’Neil’s top traders
took an account and ran it up over 70,000% (see “The
Best”) using O’Neil’s fundamental and technical indicators.
No, he was not smart enough to come up with MACD crossovers to trade
his account. But he did run his account up more than 700 times his
original value. Something I suspect (gee, I’m being nice today) the Four
Amigos sure as hell have never done. And what about all those
billions of dollars that are successfully traded every day using
nothing but technical indicators by money managers like Bill Eckhardt,
John Henry, Monroe Trout (who successfully retired from the hedge fund
industry at age 40 (see “New Market Wizards”), etc., etc, etc?

I was intending to follow-up on last week’s column discussing the
importance of having your rules put in writing and in front of you
during the trading day. There is more that needs to be discussed there
and I will likely focus on it next week.

This week, I want to talk about something that has been on my mind for
quite some time. It’s the concept of taking a trading strategy that
has an edge and potentially losing that edge by “tweaking the
rules.” There are many, many strategies that give one a head
start to having a successful trade. As we all know, it’s trade
management that ultimately dictates the success of the trade
(something the Four Amigos just don’t quite get).

Let’s for argument’s sake say that the rules of a strategy state that you
should be doing x, y and z in order to have a successful strategy.
What I have observed is that most traders will not do x, y and z. They
do part of x, tweak y and change z. Not a lot. Just enough to
“personalize” the strategy. Then, when they lose money, they
tend to blame the strategy for not working. And that’s wrong. Because
it’s not the original strategy that’s not working. It’s the
“tweaked” modified strategy that is not working. And, if you
change a strategy by one iota, you will need to trade it at least a
few hundred times before you’ll know whether or not you have improved
the strategy or more likely, killed the edge.

Let’s take some of Kevin
Haggerty’s strategies. Kevin remains one of the very smartest
traders I know. So smart, that I understand less than half he says.
But the other half gives me an understanding of the
markets that I rely upon (see my P.S. below). Kevin’s strategies have
been thought-out over a 30-year period. He has seen more trading
volume than 99.99% of the population on this earth, and his knowledge
is what helps him optimize his edge. At the end of the day, why would
anyone run the risk of trying to take his strategies and tweak them to
make them better? Yes, they may improve upon them. But, I’ll bet they
will more likely lessen the edge. Because if the tweaking really
worked, don’t you think Kevin would likely have seen it first? Don’t
you think there is the smallest chance in the world that in the
process of his creating and trading the strategy, he has modified it to
a point of optimization?

No, I do not encourage you to become a Haggerty (or anyone else)
clone. What I am encouraging you to do is ask yourself “by me
slightly changing the rules, am I killing the edge?” And, if
there is a chance you are, then trade the new and modified strategy on
paper first and see if, in fact, you’ve improved the edge or lessened
it. Because, if by changing the strategy you have actually eaten into
the edge, it’s far better to do it on paper than doing it with real
money.

Make this a rule going forward. First ask yourself, “Am I possibly
killing the edge on this strategy by doing this?” And then if the
answer is “yes,” trade it a few hundred times on paper. You’ll then
have your answer. And likely be far wealthier over your lifetime by
doing this.

Summary

First, if you have any doubt that technical analysis works, call CSFB
and read their report…you’ll chuckle at their thought process. Then,
re-read the first two “Market Wizard” books. Enough said.

On the trading front, taking a strategy and trying to make it better
is good. But, before you do, ask yourself if you are killing the edge
by changing things. I’ve seen traders make strategies better. I get
emails all the time from members who have made my strategies better.
But I have also seen traders kill the edge on strategies. And, most of
these people do not realize until it’s too late, that they took a
strategy with a significant edge and by changing the rules just a bit,
they made it mediocre. That is why I so strongly urge you to backtest.
Take your rules, go bar by bar and see if in fact, you have made
things better. Trading is about mastery. And this exercise is another
step on the road to mastery.