WHAT CAN WE KNOW FROM TECHNICAL ANALYSIS? What are the limits of Technical analysis?

Almost all of us who trade use technical analysis. Perhaps ALL.

Each of us has read the books on technical analysis, listened to proponents on tapes, and on Television, and heard stories of how we "should have known" that this or that would have happened because "it was right there on the charts". You know it is True. It is amazing how prescient some analysts can be in hindsight.

Despite theories such as random walk and efficient market hypothesis, those of us who have spent countless hours reviewing price data and more importantly watching market behavior in real time, know that there is value in technical analysis. It can be helpful in trying to make judgements about future price action. This value comes not from the charts themselves, but from what those price changes represent. Any price, at any given moment, is simply a reflection of the cummulative opinions of all those who choose to trade / invest at any given time. If only two market participants were to be involved at a given moment, and one chose to sell and the other to buy, with equal number of contracts or volume, the market would not move since these two would simply cancel each other out, with neither opinion worth more than the other.

The market however, has millions of participants, and those considering participation at any given moment. Each has a vote. That vote can be multiplied by buying power, or volume. Technical analysis will not tell us anything about any single one of those votes, but it will give us information on the value of the combined opinions. Over time, those who study technical analysis have come to recognize that in spite of its imperfections (attempting to predict future price movement from past price behavior), technical analysis does in fact, represent human behavior. And though price behavior may not necessarily repeat itself, human behavior has a tendency to repeat itself. Traders are human. We share similar emotions. We all fear, and to some extent we all are greedy. Our actions are commonly a reflection of this.

Technical analysis has been around for centuries. Wikepedia notes Joseph de la Vega's accounts of Dutch markets in the 1700's as a probable beginning. Candelstick techniques came after that in Asia. And of course any proponent of stock market study is aware of theories of Charles Dow, Elliott, Gann, and Wyckoff. We have all heard of fibonacci lines, moving averages, bollinger bands, MACD, relative strength indicators, average true range, momentum, stochastics, and volume studies like on balance volume. All of these tools strive to give the user some minimal benefit over any other technical analyst in the hopes that he might be first to recognize a trend, a reversal, or some other pattern, and profit from that recognition.

Technical analysis works. There is no doubt about that. But it works only in so much as it is a tool to assist in the analysis of human behavior, commonly referred to as behavioral economics. Simply because price once traded at a given level in the past should not necessarily affect its likelihood of trading there again. Yet if this past trading is indicative of the opinions of many market participants, then of course it may affect future price movement at these levels.

Human behavior is an interesting study. We all have developed strategies that we use in daily interractions. Most often, these serve us well,.... but sometimes, not so well. Those strategies are ubiquitous. We all use them. They reside in our subconscious, unkown lest we seek to discern their existence, which most of us will never do. And they affect every aspect of our lives. In times of stress, those subconscious strategies may make themselves known to others, though we of course may remain blind to their existence.

The market can provide stress to a degree unchallanged by other activities except perhaps combat. Whatever subconscious strategies we have unknowingly developed, they will reveal themselves when we are presented with great financial loss or perhaps the chance for similar gain. Unknowingly, the vast majority of humans react to those situations in a similar manner. And it is that which allows technical analysis to give us some insight into future market behavior.

But we must recognize an extremely important fact that Mark Douglas attempts to make clear in his priceless books Trading in the Zone and The Disciplined Trader (which you can find here). That fact is that EVERY MARKET MOMENT IS UNIQUE. Think about what that means. Every market moment is unique. It means that at any given moment in time, even seconds apart, the makeup of the market has changed. The participants are not the same, the context is not the same, the opinions of those in the market have cummulatively changed, .........each moment is different. With this in mind we can see that that though technical analysis can help greatly in market evaluation, we must recognize its limitations. It can never be perfect. We must therefore force ourselves to think in probabilities. This is something the subconscious will not want to do. Yet we must make ourselves think in this fashion. Our predictions of market behavior can never be correct 100% of the time. We must therefore recognize this and incorporate it into our trading rules and strategies.

Why do traders trade without stops? Because they think they will not need them.

Why do traders trade without a plan, and "what if" scenarios. Because they think they will not need them. (see tradernovice trading plan section) We all make trades "knowing" we will be right. Our knowledge of fundamentals, our ability to read the tape, or in this case our technical analysis has been perfected to the point that we know we will be correct. We must change that behavior and learn to think in probabilities.

Jason Jankovsky wrote a trading book entitled TRADING RULES THAT WORK. You can find it here.

In the book Mr. Jankovsky relates his trading rules. Many are quite similar to others, but in general a good read and a good review. But on page 93 of his text he makes a commentary on technical analysis that I think in priceless and often overlooked by those trying to learn to trade. He states:

The above paragraph is priceless. Read it again, please. Try as you might you cannot develop a perfect technical system. Because of this you better plan for failures and have a strategy that allows for you to recognize when you are wrong, and cut your losses.

Use technical analyis. Use any type you like. Design your own system. But please, do yourself a favor and recognize its limitations!