What to Look For in a Technical Analysis System
Do technical analysis methods work? Or perhaps more appropriately asked, how effective are technical analysis methods?
For those that simply believe that technical analysis does not work without having learned it, tried it and validated it, I submit they are missing an opportunity. For those that donít have the time or energy to do it because of lifestyle constraints (e.g. they work long hours at a stressful job), it is perfectly understandable that they bypass do-it-yourself technical analysis. For this case, I would think stock trading is also out of the question because of the time and effort needed to prepare and execute winning trades. Here, it is understandable that people partake in long-term investments and listen strictly to their financial advisors/brokers. [Witness the debacle of long-term investors locked into their holdings now awaiting recovery through time.]
For stock traders wishing to leverage technical analysis, they have to find the right technical analysis system. And with so many technical analysis indicators, it can become quite confusing, perhaps even conflicting. For example, trying to apply Bollinger Bands, Moving Average Convergence/Divergence and various Moving Average crossing points, it can become very confusing to validate which ones are effective in yielding winning trades on a consistent basis. [If it works half the time, I suggest it is not effective, because the other half means you have losing positions.]
I have read comments and discussions that certain technical analysis indicators simply donít work. I have personally performed analysis of certain technical analysis indicators and come to the same conclusion. For curiosity sake, learning about the mathematical theory behind a technical analysis indicator is an intellectually stimulating exercise, if you are so inclined. Beyond that, I think it is far more important to functionally validate the technical analysis indicators. i.e. Do they lead to consistently winning trades?
Leveraging technical analysis can be achieved in at least two ways:
- Do-it-yourself technical analysis with charting software. You analyse the charts and make your trading decisions.
- Subscribe to a service for buy/sell signals based on technical analysis. You treat the service as a black-box system and follow the buy/sell recommendations.
As long as the do-it-yourself technical analysis or the black-box technical analysis system (or a blend of the two) produces consistently winning trades, then you have validated the effectiveness of the approach and hence have found a winning formula. If you are making profits but wish for higher yields, then by all means, continue to seek and validate other technical analysis methods/systems. The fact that there are various software products available for the trader to devise their own trading system and back-test the method means people are ever seeking more. [Sometime the quest for more is simply an exercise in finding another way that may or may not yield more. But you donít know until you try.]
- Evaluate technical analysis by validating against historical data. Look at the chart, make your trading decision and do the (retro) paper-trading exercise.
- Validate against your stocks moving forward in the paper-trading exercise.
- Answer the question: Does it consistently yield winning trades?
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