A professional technical analyst earning his daily breadIn our own stock-market experience and observation, extending over 50 years, we have not known a single person who has consistently or lastingly made money by thus “following the market”. We do not hesitate to declare that this approach is as fallacious as it is popular.
Benjamin Graham, The Intelligent Investor
No, not T and A. Sorry, web-perv’s, but this entry is about my thoughts on TA – Technical Analysis.
Now, I’m sure we all know what technical analysis is – the use of price charts, in various forms, as a means of making investment decisions. For technical analysis to have any validity, you have to believe that the historical pattern of security trades has some bearing on the future price.
Back when I did my economics degree, I was taught that markets are efficient, that current prices simply reflect all that is known about a security’s propects, and that historical price patterns are no more important than the Brownian motion of gas particles. Of course, pure Efficient Market Hypothesis pretty much rules out any sensible attempt to make excess returns, so if I really believed that I wouldn’t be bothering with this blog (I used to really believe it, which is why I didn’t bother with the stock market for years).
One can, of course, believe in exploitable market inefficiencies without believing in TA; fundamentalists like Ben Graham and his protégé, Warren Buffet, have done very well indeed while dismissing TA as nonsense. And, I must admit, so much of TA simply sets off my bullshit detector: Doji Stars, Elliot Waves, Fibonacci retracements … cought, cough, bollocks … cough, cough …
And yet … the reality is that markets consist of the aggregate actions of human beings, not the random motions of bromide particles. And, the “rational economic man” of classical economic theory is just that – a theory, a yardstick besides which to measure what really happens, but no more than that.
And, the one aspect of TA that I do find convincing is the existence of trends. Mankind is a herd animal; group reinforcement is a powerful instinct. If you doubt that, simply look at recent history: once the trend of unsustainable house price rises got started, look how powerful it was, despite all the warnings, and how long it lasted. Conversely, look now how the consensus has changed.
So, as the saying goes, the trend is your friend until it ends. Trends tend to persist, and if we can devise tools for hitching an early ride, and knowing when to jump off, then we might well make some money. But, how do we define what a trend is, and what signals to use when buying and selling?
I’ve read a great deal on various TA methods, and have tried lots of them, but my favourite is based on a simple moving average-based system. The website http://www.stockcharts.com/, as well as hosting a great selection of free charts, also has a superb FAQ section. Their explanation of moving averages is better than any I could give, but the bottom line is that a moving average is simply a smoothed data series, that makes spotting a trend much easier. Popular moving average measures are the 20-day, 50-day and 200-day moving averages, which may then be described as the short, medium or long-term trend. For example, on any given day, the 20 day moving average will be the average value of prices from the past 20 days (and, because it’s a moving average, will be slightly different the following day). Thus, moving averages are always lagging indicators (the larger the moving average, the longer the lag), although the use of exponential rather than simple moving averages can alter this (see Stockcharts’ explanation if you really want to know).
Why do I prefer moving averages to other trend-identification methods? Well, to my mind, it simply seems more reasonable. Other TA approaches to determining trend lines generally involve drawing arbitrary lines on a chart, which happen to connect preceding daily highs or lows (or daily closing prices, or weekly closes, or some such approach), which looks overly precise to me. A trend is just that: a trend, a general direction which prices have taken recently and which may be continued or discontinued in future. Describing trends with geometrical precision creates a false impression of accuracy (remember that I am a skeptical technical analyst!).
So, how to use moving averages? Well, my preferred method is certainly not original, but is based on a great 2004 article from the sadly defunct http://www.tradertalk.com/ website, entitled A Simple Moving Average Trading System. While the original article appears to have disappeared from the web (and the author was never indicated), you can find a précis of the method on a couple of bulletin boards:
http://www.traderji.com/technical-analysis/21-moving-average-trading-system-15.html
http://forum.incrediblecharts.com/messages/12/546552.html
This method might also be termed the 3x13x39 system, after the three daily moving averages (dma’s) employed, viz.:
3 dma – a proxy for price
13 dma – a proxy for the short term trend
39 dma – a proxy for the intermediate trend
While the 200 dma is mentioned (a proxy for the secular trend), it is not actually used. The most important value is the 39dma, the intermediate trend. When this is flat, it indicates a ranging market, with no clear trend, and therefore no trades should be entered. If the 39dma points down, then the trend is down, so we should be looking for short opportunities; conversely, when the 39dma points up, we should be looking to go long. Entry and exit from trades is determined by the 3/13dma cross-over, viz.:
- When the 39dma is moving up, buy when the 3dma crosses up and over the 13dma and/or the 39dma. Close when the 3dma crosses back below the 13dma.
- When the 39dma is moving down, sell short when the 3dma crosses below the 13dma and/or the 39dma. Close when the 3dma crosses back above the 13dma.
And … that’s about it (I told you it was simple). However, I have added a complication in the shape of the Relative Strength Index (RSI). Remember that moving averages (of any duration) are, by definition, lagging indicators. In practice, this method will allow you to capture fairly short-to-medium term moves – a (successful) recent example being my last trade involving the Ultrashort DJ Real Estate ETF (SRS), where I netted a 64% profit in a couple of weeks. What it won't do, of course, is get you out at the top or in at the bottom – you will only identify a top or bottom once it has passed (and the 3dma crosses back over or under the 13dma). This can mean you get whipsawed around with hardly any profit, but adding an RSI rule can mitgate this tendency.
What is the RSI (Relative Strength Indicator)? Well, to turn to Stockcharts FAQ again, we see that the RSI compares the magnitude of a stock's recent gains to the magnitude of its recent losses and turns that information into a number that ranges from 0 to 100. What it actually indicates is whether a security is recently (within a specified time period, 14 days being recommended) overbought or oversold. So, what does that mean?
Nothing too arcane, really. Overbought or sold simply means that there's been a lot of recent trading in one direction, and so short-term traders are likely to be thinking of closing soon and booking a profit. In other words, it's an indication that the trend may be nearing its end (and so is no longer your friend!).
The indicator I use is the 14-day RSI, with values of 70 and above indicating an overbought condition, and 30 and below indicating oversold. How do I use it?
Well, I do my 3x13x39dma analysis first. If the dma's suggest buy, I then check the RSI – and don't buy if it's already overbought. Similarly, if the dma's say short, I don't sell when the RSI is oversold. But, this situation is rare (I try to trade only immediately after 3/13dma crosses, to be near the start of the short-term trend).
RSI is more useful when I'm already in a trade, and thinking of taking profits. Let's examine my recent SRS trade, by looking at Yahoo Finance's chart of the iShares DJ US Real Estate ETF (N.B. I always use the charts of the underlying when trading derivative instruments like leveraged ETF's).
I bought SRS on the 10th of November at $129.65, just after the IYR 3dma crossed below the 13dma, thus going short of IYR (SRS is the leveraged inverse version of IYR). I then held SRS all the way until November 20th, when IYR's 14-day RSI had declined to 29.41 – clearly oversold. Now, at that point I could have closed my position in SRS and taken a fat profit, but, because I am both greedy and skeptical, and the oversold indicator is merely an indicator (securities can go on being overbought or oversold for quite some time), what I did instead was to place a stop-loss on my SRS position, just below that day's low (for SRS) of $206.07.
That way, if IYR short-term trend was indeed at an end, I would get out fast and still bank a profit while (conversely) if the trend continued down, I could make even greater gains. As it was, the trend did indeed change, and my stop-loss got me out the next trading day at $205.45. As of November 26th, the 3dma has now crossed the 13dma, so the short-term trend is bullish (but, you should not buy IYR, as the 39dma is still trending down).
So, that's my favourite TA method, in a nutshell. Does it work? Based on personal experience, I'd say yes, it mostly does, although you have to be prepared to be whipsawed out of the odd losing trade. The biggest problem with it is that it is mostly suitable for fairly short-term trading – trends lasting a few weeks at most – rather then the really big secular moves that (in theory) really make serious money. And, of course, you do have to watch your positions more-or-less daily. Thus, I tend to reserve it for leveraged instruments like Ultra ETF's or spread-bets, so that you make big enough short-term wins to override the inevitable failed calls. It's also useful for finessing the sale of something bought for fundamental reasons, but which has since shot up in price.
Daily Express, 14th November 2008
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