The Truth About Technical Analysis
By Ryan Jones

Ask traders questions about what technical analysis is and how to use it and you will get as many answers as you have traders answering. In all seriousness, the truth is, technical analysis is one of the most misunderstood and abused topics in the entire trading industry. Throughout this article, I am going to focus first on some of the misconceptions and abuses surrounding technical analysis, and then I am going to give the proper context in which technical analysis should be viewed and utilized in trading.

1. Technical Analysis Does NOT Predict Future Price Action

Technical analysis is simply the study of price action. In order to study price action, it must have already occurred. Therefore, technical analysis is a study of history...what has already happened. Herein lies the biggest fallacy in the entire realm of technical analysis. Technical analysis does not and never will, in and of itself, predict future market action. Some will argue this fact until the cows come home...or in this case, a better analogy is until my pet fish Nemo comes home...which I assure you is not going to happen.

The truth is, traders are the ones who make predictions based on conclusions they arrive at after they study price action. Technical analysis can only tell you where prices have gone, in what manner and certain circumstances surrounding the price movement. Traders interpret the price action through various indicators. Indicators do not interpret themselves. Accordingly, it is impossible for them to predict anything. Because of this, I have outlawed the word "predict" in all of its forms with my students. It is a naughty word when associated with technical analysis.

Some say that I am making much ado over nothing. Half a dozen of one, seven of another. Tomatoes, zucchini, it's all the same. But it is not. When I analyze price action and decide to take a trade based on my analysis, I am not predicting market action; I am taking a calculated risk based on my analysis. If I uncover a particular market setup that has preceded the market moving up 80% of the time in the past, I am not predicting that it will continue to move up 80% (neither is the indicator) of the time in the future by taking a trade. Instead, I am merely stating that the risk of the market not moving higher is worth taking. By making this distinction, I am preventing myself from psychologically marrying a strategy or even a trade. This is extremely important.

2. Indicators Generally Do NOT Offer Any New Information

There are exceptions to this, but most technical analysis "indicators" do not offer any new information not already contained in the price action itself. The exceptions are in things such as volume or open interest. This offers new information not included in the actual price action. For example, Stochastics do not offer any information that is not already contained in the price action. Instead, it merely presents some or all of the information in a different format. It highlights some characteristic(s) of the price action itself. What do the Stochastics highlight? Stochastics simply highlight where price action currently is in relation to the range over the past x number of bars (standard is 14). So, if the range over the last 14 days is 100 to 150, and the market is at 140, then the market is at 80% of the range over the last 14 days.

Most indicators fall in the same category...they isolating specific information and represent it in a different way to make it easier to visually see. This further leads to evidence that it is impossible for indicators to "predict" future market movement.

3. Most Optimization in Technical Analysis Has NO Value

The end goal of all technical analysis is to uncover potential market opportunities where profit potential is worth the risks involved. Thus, technical analysis is the basis of a majority of the automated trading systems on the market today. However, there are major flaws in how systems are created and they stem from a complete lack of understanding of how to properly apply technical analysis in a practical way. The main flaw has to do with "optimizing". Optimizing a trading system has to do with finding the best performing variables within the rules created. For example, a simple trading system might be the 10 bar simple moving average crossing over the 40 bar simple moving average is a buy and crossing under is a sell. Both moving averages are considered technical indicators. A moving average is simply a running average of price action.

Let's say that our simple moving average crossover system produced 45% winners and $15,000 in total net profits over the course of a year on a particular stock trading 100 lots. Optimization finds the performing variables for the moving averages. Let's say during that time period, the best performing moving average values came in at 13 and 44. The fallacy with this is that there is no way of knowing what the best two performing values will be for this system next year. In fact, if you optimize a range of 5 - 20 (increments of 1) for the first moving average, and 21 - 50 (increments of 1) for the second moving average, you actually have 450 different combinations. This means that the odds of 13 and 44 being the best performing values for this system the following year are at approximately 1/5th of 1% (0.22%).

In layman's terms...those odds suck. Yet, despite this, system developers will constantly optimize their system for the most recent best performing variables. Let me be very clear, this process has ZERO value. It doesn't matter what indicator is used, or what system is used, there is no mathematical value in constantly optimizing the variables.

4. Optimizing to Gauge Technical Analysis Durability

As stated, optimizing for specific variables has no value in technical analysis. However, optimizing to see the general overall performance has tremendous value. What do I mean by general performance? I have seen trading systems where certain variables produce positive results in back testing, while the variables just one step in either direction produce negative results. Using the simple moving average crossover system as an example, let's say that 13 and 44 tested out as the best performing variables last year, but 14 and 45 posted negative results. Of what value is this strategy? If you answered none, you answered right.

The correct way to utilize optimization is for robustness. If 13 and 44 produce the best performance results in our example, then certainly 14 and 45 should produce positive results as well. What we are looking for is a range of positive results. We are looking for some consistency in how the variables perform. The logic is that one short-term average crosses over a longer-term average. Either this strategy works in general or it does not. Optimization reveals this vital information.

For example, the following is an equity curve of the lower moving average being tested from 5 - 20 against the second moving average variable remaining at 44. As you can see, despite where the variable was on the 5 - 20 scale, the performance was very consistent.

If you cannot view example chart 1, go here.

Compare the above optimization test results with the one below where the larger moving average was fixed at 28 while the lower was tested between 5 - 20. Notice the dramatic differences in performance from one variable to the next.

If you cannot view example chart 2, go here.

Being An Expert in Another Field Does Not Make You an Expert in Technical Analysis

There is a common pitfall among professionals in other industries that enter into the trading arena. There are successful airline pilots, doctors, attorneys, engineers and professionals in virtually every other field (except accountants) who get involved in trading. I'm not saying this happens to everyone, but it is a common pitfall...that their success and expertise gives them a free ticket when they start trading. I'm not sure why this happens, I've just seen it happen enough to know it can be a problem. One of the confusing aspects to this is the fact that those who fall into it would not fall into it with another field. For example, I have never heard of a doctor deciding that he is so successful in his field of medicine that he really doesn't need to go through all of the classes to learn how to fly a plane. I have never heard of a successful airline pilot using his success and knowledge in that field to attempt a brain surgery without being fully educated.

Perhaps part of the problem is that anyone can take a trade without any education if they so desire...and rightfully so. Unlike flying or surgery, they are not going to cause damage to someone else by their lack of wisdom. They can do with their money as they please. But it does not mean that some hard lessons have to be learned. Some of these lessons are contained in this article and can be learned without all the pain that might be associated with learning in the school of hard knocks (or with real trades and real money). Take your time to understand what you are doing. Some lessons cannot be learned outside of experience...but keep those to a minimum if at all possible.

Conclusion

There is a great deal of misunderstanding surrounding technical analysis and how to use it in trading. This is why I have developed a 10-hour online audio course called "The Truth About Technical Analysis". For a very limited time and exclusively to FutureSource readers, I am offering a 30-day access to this course absolutely COMPLIMENTARY. The course sells for $995 on our website, but you can have unlimited access to the course absolutely complimentary for the next 30-days. You will learn things about technical analysis not taught anywhere else. Begin your 30-day complimentary access right now by going to the following link.

http://www.smarttrading.com/TATrialFS.html