Common Fallacies about Technical Analysis

Definition

We start by defining our term. Most attempts to demean Technical Analysis start with faulty layman definitions. People often get lost on this very first step, maybe because the top search result sites, like Investopedia, give an oversimplified and erroneous definition.1 However, when we look to industry professionals and more comprehensive sites like Wikipedia, we can form a more productive definition.

Technical analysis (TA): 1) an analysis methodology for forecasting the probable direction of future prices through the study of past market data, including price history, relative price history, price movements through time in relation to empirical market data, volume, price formation and the basics of economic calculation, market sentiment and investor psychology.2 3 2) Technical analysis is not trading, it is forecasting. TA must be combined with an individual skill set, including a proclivity for risk management, consistency, calm temperament, open mindedness, etc. to be profitably applied to trading.

The antagonistic definition, goes something like this, ‘TA is trading based only on “trends” and “patterns” in charts, which our monkey brains are hardwired to recognize, but really don’t hold any significance.‘ It’s not hard to cherry-pick bad examples of TA, as I discuss below, we can agree that many TA practitioners are bad. Then again, we aren’t interested in bad TA, we are trying to find out if any TA has merit. This antagonistic definition excludes any mention of probabilities, forecasting, entrepreneurial risk, or differences in individual skill. It’s a lazy attempt to avoid the question, used by people to project their monkey brains onto others.

Most People Lose Money Trading

People often throw out the hackneyed fact, most people lose money trading, as proof TA is illegitimate. TA is not trading. But for sake of argument, I’ll point out that most entrepreneurs fail, too. Economic results of high risk market activity concentrate on the a small portion of the participants. The distribution of success is, however, a point in favor of the legitimacy of TA. By saying “most people lose money,” they imply not all people lose money. Most inventions or startup ideas are absolutely wacky and fail immediately, but does that mean innovation and entrepreneurship are akin to numerology and astrology, like is said about TA? A good faith discussion will concern itself with the successful side of this distribution.

Prove It

Another fallacy is insisting on exact predictions or empirical proof from the individual in the debate. Misguided skeptics want TA practitioners to make a call, so when it fails, they can claim it’s proof TA doesn’t work. This is wrong for a couple simple reasons. First, TA involves probabilities and human learning. A sample size of one or two predictions, is not nearly enough to conclude anything about technical analysis in general. At most you could conclude something about the current state of that individual’s abilities. Secondly, would the skeptic accept a correct forecast as confirmation of TA’s validity? Probably not. This is an unfalsifiable pursuit, from a person claiming to be interested in scientific empirical data. The best evidence we have is the existence of people who consistently beat the market.

Only Scammers Sell TA

Lastly, I need to tackle when TA skeptics say something along the lines of, “those who know, don’t tell.” In other words, if a TA practitioner really has asymmetric knowledge and is able to beat the market, they wouldn’t share it. Therefore, anyone who does share their charts is by definition a scammer. That is partially true, I won’t deny scammers are attracted to abstruse fields with high margins, however, trading is inherently risky. Someone might have great technical analysis, but they are highly risk averse. Remember, TA is not trading. Selling price calls is less risky. For example, if the probability of a price move is 70%, and the individual’s risk tolerance only allows for a 5% probability of failure, they would rather sell their TA than partake in the trade. Also, diversifying your income is always a smart idea. It makes sense that even very successful traders should desire multiple revenue streams, especially if their risk tolerance is low. It’s that simple. Also, people who tell you, “those who know, don’t tell” expose an inability to spot obvious inherent contradictions.

To recap the major fallacies:

  • The definition of Technical Analysis includes much more than lines and patterns on a chart.
  • TA and trading are two separate concepts. Forecasting versus profitable application.
  • Returns on trading logically follow a Pareto distribution, so yes, most people lose money, but that says nothing logically about the legitimacy of TA.
  • The probabilistic nature and human learning make empirical proof difficult (impossible?).
  • Those who know, can “tell” to diversify income and lower their risk.
  1. “Technical analysis is a trading discipline employed to evaluate investments and identify trading opportunities by analyzing statistical trends gathered from trading activity, such as price movement and volume.” TA is not trading itself, it’s a forecasting methodology used by traders. Price is not solely the result of “trading activity.” – https://www.investopedia.com/terms/t/technicalanalysis.asp
  2. Wikipedia; https://en.wikipedia.org/wiki/Technical_analysis
  3. Stockcharts.com; https://school.stockcharts.com/doku.php?id=overview:technical_analysis
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