Technical analysis & its ‘inverse’

December 13th, 2007

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Today, we will deviate from our usual discussion of macroeconomics and talk about tools for short-term trading- technical analysis. According to the Wikipedia, technical analysis is:

Technical analysis is the study of market action, primarily through the use of charts, for the purpose of forecasting future price trends.

Do we believe in technical analysis? As we commented before in Telstra?s share price vulnerable in the short-term,

Some analysts may scoff at technical analysis and place it in the same league as astrology. But for us, we prefer to be agnostic about it. The reason being, since there are so many traders in the market employing the use of technical analysis, it will become a self-fulfilling prophecy.

Whether you believe in technical analysis or not, you will do better to understand the root philosophy of technical analysis and thereby, be aware of its weaknesses, limitations and pitfalls.

First, what are the root assumptions of technical analysis? Technical analysis is based on the premise that:

  1. The price behaviours of the market/instrument exhibit repeatable patterns.
  2. The price reflects all known information about the market/instrument. That is, there is no need to study the fundamentals because the price has already reflected them.

Therefore, technical analysis uses statistical probability to take a stand on the likelihood of future price movements. In other words, it uses what happened in the past as a guide to what may happen in the future. For example, a technical analyst will base his/her trades on interpretation of patterns in the charts.

But this implies a major weakness of technical analysis- it is vulnerable to Black Swans. As you may recall in our earlier article, How the folks in the finance/economics industry became turkeys?Part 1: Parable of the turkey, a Black Swan event is

… one in which it is highly improbable
but has colossal impact.

By definition, a Black Swan event is close to impossible based on statistical probability. Therefore, it is something that is completely ‘unexpected’ by technical analysis. In other words, the Black Swan is the blind spot of technical analysis.

Interestingly, there is a rare breed of traders who uses what we call the ‘inverse’ of technical analysis. They seek to profit from statistically rare events (i.e. Black Swans). To be able to do so, they have to construct asymmetric payoff strategies. In view of this, our article series, How to profit from a stock market crash?, is an example of ‘inverse’ technical analysis (this phrase is our own invention- probably it is not used anywhere else).

Thus, by all means learn and use technical analysis if you intend to trade short term. But bear in mind, it has its own blind spot.