Hmm… this debate has been on for many many years now. I think you will find enough content online which is for & against technical analysis.
Firstly there is nothing in the stock markets that just “works”. If there was any guaranteed way to profit, it will be traded on until there isn’t any. So when you look at charts, and see some indicators or drawings and if it seems like, “Damn, this works”, it is because of hindsight & selection bias.
It is when you feel after an event is over that you could have accurately predicted that it happened. This feeling gets accentuated when you selectively look at only certain events.
So, I don’t think there is any entry or exit strategy that “works” when trading the markets, technical analysis, or otherwise. It is all about trading higher probabilities of something working and an unemotional risk management system. This is where technical analysis works well, especially for retail traders.
Most TA strategies are trend-following.
This means if something is going up you buy and if something is going down you sell. Instinctively most of us try to do the opposite, one of the biggest reasons for retail traders to lose money. In TA by mostly trading with the trend of the stock, you increase the probability of winning when trading – slightly. But here is the thing, that slight difference matters.
I suggest you to watch this brilliant talk by Stephen Duneier at Ted Talks. He shares how Djokovic went from being #600 in the world to #1 just by increasing his success rate from 49% to 53%.
By the way, trend following is also what we have to do in all walks of life to increase the odds of succeeding. Be around people who are doing well, work in companies doing well, take courses and upskill based on what is most in demand, etc. But that doesn’t mean to say that outliers or people who go against the trend don’t succeed. Just that the probability of success reduces. Btw, passionate outliers who get lucky also tend to be called disruptors and usually have massive outsized returns, that is provided they get lucky. But luck or hope, unfortunately, isn’t a strategy that you can rely on when trading or in life. Hence trend following is usually a safer and better option for most people as most don’t understand the concept of risk to reward and also because you shouldn’t be taking higher risks before spending at least a few thousand hours trading/learning the markets.
Risk management
When trading using TA, there is usually a defined stoploss or a point where you exit if things went wrong. Not exiting a losing stock is also what hurts retail traders the most (loss aversion bias). The best bit of Technical analysis is that there is a defined stop-loss on every trade, and helps in the most important aspect of trading – Risk management.
Btw, on a related note, here is a discussion I had with Jack Schwager a few years back. You can check the full video here. If you haven’t read Market Wizards from Jack, make sure to go read them, they are amongst the best for anyone trading the markets.
Nithin: I’ve heard about your transition from being a fundamental trader to becoming a discretionary technical trader because of all the risk management benefits you got from following technical analysis. Can you talk a bit about this?
Jack Schwager: It’s kind of interesting. I am not pushing anything but I’ve interviewed traders who made millions or hundreds of millions on fundamentals so I am not knocking fundamentals and it’s right for certain kind of people. I’ve seen both kinds, traders who have done tremendously well with fundamentals and traders who done phenomenally well with technical.
But for myself, the problem I always had with fundamentals is that inherently in the approach, the more wrong you are the more sense it makes to add to the position. So, if I think that some market is underpriced let’s say at $6 and I go long because my fundamentals tell me that this is cheap. If this goes to $5.50 and nothing has changed then it logically means that it is an even better deal and that I should buy more and to certainly not get out.
Not only does fundamentals not have any intrinsic risk management, by its very nature anti risk management. Because if you are trying to assign a value to an item and if it is going against with any change and I emphasize without any change in the facts as a fundamental trader your logical step would be to add to a losing position.
This from a risk management perspective isn’t very good. Whereas in technical if you are going with the trend or even against a trend I can say that I can expect the market to fail in this zone and if it goes beyond the zone by a 100 points then my call is wrong and i am out. Even if you are going with or against the trend you can apply risk management because technical analysis establishes an area where you want to either buy or sell.
Any reasonable approach you have should allow for asking the question “Where am i wrong?” and that allows for placing a risk management stop. Whereas in fundamentals the market going against you is not a sign that you are wrong but rather a sign that you should put on more.
So, that’s the crux of why I completely transitioned away from fundamentals but again I’ve interviewed many people who think that technical analysis is a bunch of malarkey and have done tremendously well on fundamentals. So it’s really about what’s right for you.
And finally, to use technical analysis in today’s world there aren’t any large entry barriers. It is easy to learn and get started. Almost every trading platform gives you access to good quality charting. And today you have platforms/APIs where you can backtest strategies so that you are not affected by the sample selection bias. By the way, if you don’t know to program, you can check out Streak (one of the startups we have partnered through our incubator/fintech fund Rainmatter).
Hopefully, this helps.