The Weakness and Strength of Technical Analysis

I have not always been a big fan of technical analysis. I couldn’t make any sense of why these trendlines could predict support or a change in the prevailing trend, or why head and shoulders patterns would highlight a top formation and why technicians were basing themselves on various geometric forms (!) to make a trading decision. 

A lot of smart people I know will dismiss technical analysis as a technique for charlatans or will compare it to astrology. 

While technical analysis alone is not sufficient to trade markets, I learned to understand that you c.a.n.n.o.t. d.i.s.m.i.s.s. i.t. 

My view of technical analysis changed when I met Linda Raschke. She recommended to me the book Mind Over Markets, a book written by Jim Dalton, a former pit trader in Chicago. Jim did a phenomenal job explaining how auction markets work and how, as a trader, you can read those price gyrations to make up your mind on the next trade opportunity. The study of auction markets made everything more clear to me. Now, I could see structure in market price gyrations while others only saw noise or chaos (well not always of course!). I could better understand the dynamics of auction markets and why technical analysis was actually an amazing tool to trade a big number of different markets which is what I’ve always wanted to do as a global macro investor. 

Technical analysis allows me to trade a high number of markets, without having to be a specialist in any of them. It gives me SPEED and AGILITY that no other technique to trade financial markets can give me. It can do the same thing for you !

Speed and agility are important when you actively invest in financial markets on a risk-adjusted basis.

However, TA needs to be used with context and nuances. TA is like your car’s steering wheel, dashboard indicators and shifting gear taken all together. They certainly play a crucial role in making sure you can go from point A to point B without killing anyone or falling in a ditch. But they are only one component of a greater apparatus, the vehicle. It is nothing more. It helps you go from point A to point B but there will always be obstacles and bumps ahead. One thing is certain: you would not be able to drive your car without them.

The thing is you can’t drive your car by looking only at your dashboard. TA without broader context is the same, pretty much useless.

As such, in trading, TA will be misleading if you don’t notice the broader context and filter through the noise.  It’s easy to focus too much on certain indicators, patterns or setups and find the right example on a given timeframe that will get you excited. 

Oh, look, we just had a moving average crossover and the market tanked 1 000 points. Yes, sometimes they will work just on their own, but most of the time, they will be misleading if they are taken without context. 

The same goes with backtesting. You can eventually find an exciting strategy that has given good results through backtesting but if you only rely on that one strategy alone based on prior results, chances are you will be very disappointed when you forward test that strategy with real trades.

By context I mean the bias that you have, based on your assessment of the macro-structure of the market followed by your assessment of real-time price action. 

Always keep in mind that both go hand in hand, although they will diverge on many occasions. Price action analysis without a greater macro context can really mislead you. On the other hand, because markets are forward looking, price action analysis must always be at the top of your list as some of your trading ideas might take some time to play out. 

In the meantime, always be ready to experience whipsawed action for a much longer period of time than anticipated. Markets are resilient, and noisy a lot of the time. The bigger moves often happen when a sufficient number of market participants have been trapped on one side of the market or gave up on that market, or when a majority of participants believe in a narrative that fails to materialize. This accumulation characterized with whipsawed action may take years before a cyclical or structural trend happens.

An encyclopedia of Patterns like the one below, taken without context, cannot and will not make you rich. Head & Shoulders patterns mean absolutely nothing without context. They are simply an indication of a possible exhaustion price setup on a given timeframe, and nothing else. Understanding value areas, price oscillations and price rejections, key levels, and price reaction when new important information arises are the most important aspects of technical analysis. Tone down the importance of chart patterns. Focus on context and price action with respect to key pivot levels. 

But yes, chart patterns can help you improve your trade location.

Be aware of the noise and respect it. Don’t get frustrated in a noisy environment. Noise is a key characteristic of financial markets. Think about it: there are millions of investors making billions of transactions per day !

In my opinion, noisy market conditions represent between 30% and 50% of market action. And as we have seen with the power of diversification and relative performance, you can profit from noisy markets by allowing your portfolio to swing relatively smoothly on a risk-adjusted basis and take profit on a regular basis. You’ll just need to play for smaller targets in noisy conditions.

TA also becomes more useful when you combine more than one timeframe to trigger your trade ideas, entries and exits. TA is also the best tool to execute on the best risk-reward trades. Everything we are going to see here is applicable to all timeframes regardless of how zoomed in or zoomed out you are, like fractals. However, shorter timeframes should only be used by experienced, full time traders as they know better when to dismiss short term swings in favor of a bigger picture move.

It’s clear that if I had to pick between fundamentals and TA, I would always, always, always pick TA. Because TA represents the truth at any given moment. Fundamentals are always distorted by price action as we have seen with the reflexivity concept.

Good night and good luck!