Supplement– Technical Analysis

The following quote resonated powerfully with me after about a year and a half of trying to learn technical analysis. It galvanized my frustration and led me to give up the whole endeavor.1

“Thinking about momentum led me to wonder whether past prices could somehow be used to predict future prices. To test this, I looked at charting, the art of using patterns in the graphs of stock (or commodity) prices to forecast their future changes. I was introduced to this by Norman, a Canadian resident living in Las Cruces, while I was teaching at New Mexico State University. After months of examining his data and predictions, I was unable to find anything of value. As [wife] Vivian said at the start, “This is going to be a waste of time. Norman’s been doing this for years and you can tell he’s barely getting by. Just look at his worn–out shoes and shabby clothes. And you can tell from the quality of his wife’s old and outdated outfits that they were once better off.”

Ed Thorpe, A Man for All Markets2

Ed Thorpe, the man with the plan.

Some people swear by technical analysis, and some of them are successful traders. Some of them are purported to be very successful traders.3 But they are rare. I do not think believing in or using technical analysis means you will not be successful; they are not mutually exclusive. There is some credence to the notion that if everyone is using the same momentum indicators, then they could constitute a self-fulfilling prophecy. However, in my experience technical analysis works. . . until it doesn’t.

What Works, When?

I realize technical indicators have value for some people. If they at minimum add confidence when entering positions, or at most actually do predict future prices, that’s great. But I would submit to you the following evidence against their use as a retail investor.4 Firstly, they don’t always work, so then the question is raised “does technical indicator X work more often than not? If so, in what situations, with what % of success?”

Show me a technical analyst who publishes all his predictions and results in a completely transparent manner and I’ll show you someone I’d climb Mount Everest to learn from. Furthermore, if there are some high–probability technical indicators, I’d assume an algorithm has figured them out. Couldn’t what they are and when they should be applied, in theory, be automated in a way that we can’t begin to compete with as retail investors?

It’s All About Perspective

Secondly, most technical analysis is HIGHLY subjective. Anyone can draw lines on a chart to identify trends (stockcharts.com is a great free tool for this, and very fun to play with), but the level of individual interpretation at play is too much to make it anything but an art in my estimation. Simply changing the time frame gives you totally different patterns on a chart, so I just never understood how one knows they’ve picked the relevant trend, or pattern, or cup and handle etc, etc.

But there is also a very dark side to technical analysis that this individual interpretation lends itself to: advertising to retail investors. Whenever you see any ads for something akin to Surefire Trading Patterns or Killer Chart Strategies, I would advise you run. 

A Great Review

If you need a more entertaining reason to run, head on over to Investimonials.com5, one of the most amazing websites ever created in regards to paid investment advice services. Here you can see a lot of great reviews of questionable validity . Interspersed within these rave reviews there’s inevitably a furious investor who was grifted for a significant sum of money trying to learn aforementioned Killer Chart Strategies. I remember reading about technical analysis-based trade alert services (at the time, I was considering paying for one in order to learn and be competent myself – I’m glad I never did). In searching, I came across a long, exasperated review nestled in a group of overwhelmingly positive ones for a popular service that was being targeted-advertised to me nonstop on a popular internet video site.

This Poor Guy

The reviewer said he bought the initial program, then paid for a subscription service. Then paid for all the extra “advanced strategy” DVDs. In the hole for close to $1,000 (I looked through the reviews at the time of writing but this one had ominously disappeared, so forgive me for going off memory), he then paid even more to go to an in–person seminar so he could learn from the face of the company live, and have a chance to bring his own examples and ask why the strategies didn’t work. Said guru proceeded to tell him he incorrectly identified patterns, mainly because he chose the wrong time horizon (among other reasons).

This is a great “out”, as changing the length of data completely changes the trend, and no one will ever give you a real answer of when to choose what horizon. Guru then ridiculed the person in front of other attendees for his inability to learn the simple trading secrets. Finally, when confronted about his trade alerts, which often were emailed to subscribers seconds before (or after!) a price changed, the guru claimed that with multiple positions open, no one could have a 100% win rate. The investor should have diversified his risk better (position sizings were not included in the alerts) and been more nimble entering and exiting positions. Additionally, they were told that they should rely on the skills that they learned. The alerts were also of an educational nature, not a trading strategy.

Allow Me To Rant

I find this infuriating. If you are truly going to claim that you have the secret to making money in the markets you would probably have to do the following:

  • Understand risk diversification, which involves learning higher level mathematics, including The Kelly Criterion
  • Do historical testing on the probability of your trading patterns being successful
  • Apply that to your strategy
  • Develop a self correction mechanism for your strategy. Backtesting is similar to regression analysis- it tells you what worked the past, not what is going to work in the future
  • Tell the subscribers of your fantastic service exactly what the portfolio allocation should be. All buys, sells, entries, exits, percentage weighting of positions. The whole shebang… and 
  • Get a third party to verify it. 

“Don’t tell me what you think, tell me what you have in your portfolio.”

Nassim Nicholas Taleb, Skin in the Game: Hidden Asymmetries in Daily Life

More importantly, tell them exactly what your portfolio allocations are. Not the trading one you are hocking, but your actual, real life retirement portfolio.

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Further, tell them exactly what percentage of that portfolio’s returns are based on the service you are selling, or alternate investments like real estate or the fast food franchise you may own.

Worried about our weird morals surrounding money? I’m sure someone could make a program that would blind the actual dollar value and convert it all to percentages for educational purposes. In fact, it’s a stellar business idea, and you could sell it to all the trading gurus on social media so they can share ALL their trades and retain privacy.

When that exists, then I’ll be chomping at the bit to sign up for some trading services.

Unfortunately, most guys selling a trading service don’t do this (let me know if there is one). What you see is more often than not a combination of moving averages, MACD, and doji candlestick patterns. 

Keep Your Cash

Don’t fall for it. 

I can teach you how to trade covered calls. I don’t know what will maximize profit every time– no one does.

Now, I can’t make general claims, and there may be awesome subscription-based services out there. But if you are going to pay for one, be careful. If you find some technical indicators that work, or services that are worth the price, awesome. Please drop me an email about them.

In the meantime, be careful, and don’t buy any “secrets”. I personally don’t sell any services like this or boast about investing returns because I can’t tell the future, but I can tell you how to trade options – I know that with confidence, and I’m happy putting that out there, because it’s the truth.

Caveats, Galore

That being said, there are guys on twitter who trade stocks mostly on a combination of TA (technical analysis) and due diligence, post their trades, and are successful. . . sometimes. That gives me a creeping feeling of dread that I’m missing something. I just don’t know, and that’s hard for me to say because I sincerely tried to understand and couldn’t. I respect these guys because they are transparent, free, have some good picks, and have made me some money.7

But I’ve also lost just as much on their bad calls. So, if you are a huge proponent of T.A. don’t construe this chapter as me thinking technical analysis is BS. Like most things it’s complicated, and it just may be the case that I don’t understand it.

Takeaway

In closing, like Ed Thorpe, I was unable to find anything of value.8

Spoiler Alert: The Last Lesson

When asked to sum up the investing lesson one could take from Ed Thorp’s autobiography a friend who read it the same time as me (hilariously) replied: “Be as smart as Ed Thorp”.

Although this isn’t possible for most people, you can take Ed Thorp’s advice, contained in the last chapters of the book.9 Spoiler alert— it’s the same as Mr. Money Mustache’s take on the topic.


Invest in index funds.

  1. There’s another important lesson here. Even one of the sharpest logical minds to have ever lived can sometimes miss the nuance that other types of thinking are attuned to. Besides recognizing the inadequacy of his perception (humility), the fact that Mr. Thorp holds his spouse in high regard, and values her for her qualities (qualities far removed from the world of a quantitative mathematician) is downright heartwarming. [↩]
  2. 2The best autobiography I’ve ever read, and another one of my favorite books. It’s even better as an audiobook because Thorp narrates it himself, and there’s some raw emotion in there. Pairs well with “Fortune’s Formula”, a book detailing the derivation of the Kelly Criterion and the other characters and influences in Thorp’s life. And if you want to read Thorp directly to round out the trifecta, “Beat the Dealer”, the book that described his card counting method for blackjack, is very accessible to the average human.
    Of note, Nassim Nicholas Taleb wrote the forward. [↩]
  3. See “Unknown Market Wizards” by Jack D. Schwager [↩]
  4. This is all personal experience, N = 1. Plus I’m not a genius so maybe I just didn’t learn it well enough? shrug [↩]
  5. I recently visited this site, and sadly most of the negative and in-depth reviews seemed to have disappeared 🙁 [↩]
  6. I sell covered calls with index funds and ETFs on about 5-20% of my tradeable portfolio. Over different time horizons, my estimated returns vs appreciation on the underlying funds matches the market, +/–5% (yes, that’s a minus sign. We know covered calls cap upside- it’s how they work). I wasn’t tracking closely the first few years I was doing this, I don’t consistently reinvest, and I was trying other strategies all the time in the same account hence the estimate. Also notice I said tradeable; more than half of my retirement is in traditional employer-administered plans. Overall though, since I’m strict with selling only OTM and always above cost basis as described in the book, underperformance usually only happens on years the market is raging. [↩]
  7. When I used to follow along and trade their plays for fun— I don’t anymore. [↩]
  8. I’m dumb, but I know for damn sure that Ed Thorp is one of the smartest humans alive and one of the best investors to ever live. Also of note, Thorpe did develop a trading system dubbed MIDAS which may have included some technical analysis. He describes it as follows “. . .indicators we systematically analyzed, several correlated strongly with past performance. Among them were earnings yield (annual earnings divided by price), dividend yield, book value divided by price, momentum, short interest (the number of shares of a company currently sold short), earnings surprise (an earnings announcement that is significantly and unexpectedly different from the analysts’ consensus), purchases and sales by company officers, directors, and large shareholders, and the ratio of total company sales to the market price of the company. We studied each of these separately, then worked out how to combine them. When the historical patterns persisted as prices unfolded into the future, we created a trading system called MIDAS (multiple indicator diversified asset system) and used it to run a separate long/ short hedge fund.” So maybe he did crack the code. . . Like I said, it’s complicated. [↩]
  9. Everyone should really read it, and although I prefer actual, physical books,
    in this case the audiobook is even better because Thorp narrates it himself. [↩]