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5 Big Myths of Technical Analysis

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Is there one system of technical analysis that makes all the others crumble in defeat?

If there were, giant quantitative trading houses like Citadel and Renaissance Technologies would not be employing hundreds of PhDs in mathematics, engineering, and computer science to develop hundreds of new algorithmic programs for exploiting market opportunities.

But does that mean we should abandon technical indicators as a bunch of inconsistent noise that we can't use to compete against the quants' mega firepower?

No way! There are plenty of terrific technical tools and methods that can enhance your stock selection and swing trading. But first, you need to clear away five big myths and pitfalls that get in the way of seeing how to use them.

1) Everything Is Reflected in Price

Even though over $8 trillion is indexed to the S&P 500 for fundamental reasons by mutual, pension, insurance, and hedge funds, the pure technician believes that the chart holds all the information you need about supply and demand for a stock. They say you don't need to pay attention to fundamentals because "price tells you what the institutional investors think of the fundamentals."

But using a simple indicator that measures earnings momentum -- the Zacks Rank -- I can show you how thousands of stocks were first discovered to have potential fundamental greatness that led to tremendous returns.

Consider The Trade Desk (TTD), the automated exchange for digital, omnichannel advertising. The Zacks Rank spotted this one as a winner at $50 in early 2018 and every quarter of positive earnings surprises and upward estimate revisions kept TTD a Zacks #1 Strong Buy as shares climbed above $250 this month.

Another terrific example has been Veeva Systems (VEEV), the specialty software platform provider to pharma and biotech companies. VEEV became a Zack #1 Rank Strong Buy in early 2017 near $40 and the stock vaulted 85% this year to $166 as it consistently earned that rating for 5 straight quarters of beat-and-raise goodness.

Traders who only look at the charts questioned me every time I recommended buying these stocks many had never heard of. Their charts told them to sell, while the Zacks Rank and my trend indicators, plus institutional "behavioral" sentiment, told me to buy.

If markets were completely rational and efficient, smart investors who combine "technicals" and fundamentals would not have doubled or even tripled their money swing trading TTD and VEEV shares the past two years.

2) Trend Lines Are Meaningful and Predictive

Markets are the most complex and dynamic systems on the planet. Indeed, they are social cauldrons with nearly infinite variables and geometric drivers. So why do "old school" traders still draw straight lines connecting price highs and lows -- over months or even years of economic events and data -- and expect a non-linear system to obey them?

Because they are simply stuck in the sacred rituals of the past. I predict that one day very soon the venerable leaders of technical analysis societies will abandon trend lines as mathematically absurd.

More importantly, I am busy forecasting which highly-Ranked stocks are lining up with my preferred technical indicators to signal great buying opportunities.

Continued . . .


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3) The Algos Have Taken Over the Game

As I mentioned in my intro, the quant houses and their computer "algos" have changed the game a little bit. Since they can move large amounts of money very quickly, in and out of stocks with completely-automated risk control, they have no fear... and lots of profits to count.

And they also exploit lots of traditional technical analysis with their hammer-blow strikes, forcing false breakouts and breakdowns, toying with trend-line traders, and manipulating volume and price with off-exchange "dark pool" trades.

But they do not own the game because stocks and trillions in investment dollars still follow one eternal trend force that supersedes the daily chop and weekly volatility: long-term earnings momentum. And that means your job as a trader is to use technical analysis to spot killer entry and exit opportunities in fundamentally-strong stocks.

4) Magic Numbers Exist for Moving Averages

I traded currencies at the institutional interbank level for a decade. As an FX market maker providing liquidity to the biggest banks and hedge funds in the world, I traded an average of $100 million per day.

During that time, I ran back-tests with years of price data to find the "optimal" moving average combination for any time frame. Guess what? No combination was consistently better than any other. No magic numbers or Fibonacci sequences made any more difference than simply using multiples of 5 or 10 and bands of support and resistance.

In most cases, keeping it simple and consistent with technical indicators really works because the critical skills involve your research process, execution, discipline and risk management.

5) Trading is Simple and Requires Only a Few Chart Setups

Simplicity works to manage the info-overload of markets. But, there is a big misconception that anyone can walk into the trading arena with a few simple chart setups or indicators and cash in.

The truth is that building expertise in trading can take many years of mistakes, losses, and frustration before you cross over into a realm where you know how to balance all the macro noise and news with your own solid research and discipline -- and a probability-based mindset that knows how to beat the emotional demons with math, logic, and calculated risk.

For instance, did you know that your brain is emotionally hard-wired to break the "golden rule" of trading? Cut thy losses short and let thy winners run is so hard because human behavior is predisposed to emotionally overreact to fast-moving green and red bars as your account value fluctuates and greed, fear, worry and regret take over.

You Break the Golden Rule, You Break Your Portfolio

In short, most traders hate to take losses and they grab most gains far too quickly, which is the recipe for a busted trading account.

So even if someone hands you a top trading system or set of rules, you still have to learn the mental and emotional game, and sort through the jungle of technical indicators, patterns, and advice-givers. I'm grateful I did all that work over the past 2+ decades.

But I wouldn't want to start there again without a guide to show me the way. I hope my myth-busting helped you a little -- or a lot -- on your journey as a trader.

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Of course, you can uncover some of these enhanced trades on your own if you start with the 880 Zacks Rank #1 and #2 stocks. There isn't a better fundamental indicator of what and when to buy. Then reduce the list down to an investable few by adding technical signals for even greater accuracy and timeliness.

That may sound simple, but as I suggested earlier, it takes more than a few chart setups to catch the right trades at the right times - and it can take years of learning through trial and error to get good at it.

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Good Investing,

Kevin

Kevin Cook, Senior Stock Strategist at Zacks, is a leading expert in technical analysis and what makes markets move. He provides commentary and recommendations for the Zacks TAZR portfolio.