Why does technical analysis work?

Technical analysis describes different ways of predicting the future of the stock/futures market based on its history. Unfortunately, technical analysis is not an exact science.

Many prominent scientists label it as "voodoo science". They claim that due to market efficiency, if you use TA to find your entry positions, you're no better off than someone who chooses those positions randomly. Market efficiency means that all the available information is already calculated in the stock prices, and that you can only guess how the price will behave in the future.

The "voodoo science" theory would make sense if it wasn't for the fact that there is a significant number of traders who are able to consistently make profits in the stock/futures market.

These traders use technical analysis as their main tool. Since any trader has or can have access to the same TA tools we have to ask how can a small group of traders consistently win and the other larger group, more or less consistently lose in the stock market game.

What is it that winning traders know about technical analysis that gives them the upper hand?

The answer is simple: Technical Analysis works but not necessarily for the reason most people believe. Many successful traders don't want to share this secret. TA works because many people use it, and successful traders are able to predict how other people will react on the different TA indicators and signals. In other words, while the losing traders are using TA to determine their trades, the winning traders are winning because they know how the losers are going to react based on this data.

For example, when a price goes below one of the key moving averages, (MA's) many investors sell that instrument to protect themselves against additional losses. By doing so, they will drive the price of that instrument lower and that will prompt some traders to start short selling that instrument in anticipation of further decline. Prices continue the downward trend, forcing traders who were long on that stock to sell their positions because it is going below their stop limits. This creates a domino effect as the price continues to decline. However, at this point, successful traders realize that most of the current price action was created artificially. They start to enter positions on the buy side and more often than not price starts to reverse. The losing traders have already sold their contracts based on the TA tools. The winning traders buy the contract because they understand that the fluctuation was temporary, and they seize the opportunity based on the losing trader's reactions.

No TA tool by itself will give you reliable buy or sell signals. There is no Holy Grail or magic black box that will give you the perfect, accurate signal. However, the combining of the right group of TA indicators with discipline and adequate trading capital has been the road to fortune for many traders. There is no reason why you cannot emulate their success. Let's take a look at an example.

Understanding Pivot Points

Pivot Points are those price levels that are most likely to act as levels of support and resistance on any given trading day. As we already know, Technical Analysis works because many people use it. For the same reason, the most influential pivot points are those that are used by majority of traders. The most widely used formula for calculating pivot points is as follows:

H = previous day's high

L = previous day's low

C = previous day's close

Pivot Point = (H + L + C)/3

Resistance = 2*PP - L

Support = 2*PP - H

Previous day's last two hour high = L2HrHigh

Previous day's last two hour low = L2HrLow

When the price moves through the known pivot point on increased volume it is most likely to continue current trend, and if the price hits the known pivot point but is unable to move through it is most likely to reverse the current trend.



Figure above is a 5-minute candlestick chart for S&P 500 E-mini contract and you can observe how the Pivot Point was acting as a major support line throughout the trading day. When the advancing/declining price is not able to move through the known pivot point after two or more tries there is a good probability that it will start to decline/advance. Trading method in which a trader is waiting for a price to reverse after hitting S/R level is called swing trading. On the other hand if the advancing/declining price has easily moved through known S/R level there is a good probability that it will continue to advance/decline. Trading method in which a trader is looking for a price to continue to move in the same direction after moving through S/R level is called breakout trading.


Zoran Kolundzic

Day Trader Skills

Trading is like most business: it requires commitment and perseverance. It is never easy to make money, but people who have mastered a skill make it appear easy. The really successful pit traders that I have known made trading look very easy, tantalisingly easy; but they all had many years of experience behind them. For every successful trader there has probably been a few hundred who have tried and failed.

Two core skills
I think people fail at any business if they approach it without an appreciation and understanding of what is required for success. The majority of traders fail, because they have no such appreciation and they have unrealistic expectations of themselves. Any trader who starts with the expectation of becoming an instant success is setting himself up for failure.

No one would decide to become a golf pro and assume that they could just pick up a bag of clubs and start winning tournaments. Yet novice traders do this all the time. Just to start with the understanding that trading is a skill that is developed over time, through experience, puts a novice trader way ahead of the competition.

There are two core skills in trading: first the ability to anticipate the market (read the market) and second, having the discipline to execute your plan. To learn to read the market you may as well use a trading simulator and only start to trade when you have demonstrated to yourself that you can anticipate the market. Discipline, though, has to be developed and tested in the real world.

Stick to your own rules
Discipline is really the crux of the matter and it is here that most traders fall down. Their failure is mainly due to the fact that they are not really aware of its importance. Just starting out as a trader with the intention of developing your discipline puts you way ahead of the average trader. If you can trade with discipline (i.e. stick to your own rules and limits) you are 95% there!

So I would say that for the average aspiring trader, trading is a fool's game; but for those of us who approach the business as a business, with a clear understanding of the unique challenges that trading offers, it is a rewarding and fulfilling career.


Malcolm Robinson

Day Trading Strategy

Reading Gary Smiths book "How I trade for a living", I came across a reference to an interview with Donald Sliter, a top S&P floor trader. When asked about his trading strategy he had replied that it is a matter of understanding strength and weakness.

When asked to expand on that, he said, "I scalp to the short side if we are trading weak to the Dow. I scalp to the long side if we're trading strong to the Dow." The interviewers were amazed that one of the biggest traders in the S&P pit had such a simple strategy.

For me, this reinforces the idea that as an active day trader of the futures market, it is not about developing complex, high probability strategies; it is about having simple, logical, high frequency strategies that give an edge. There are different approaches to creating an edge in trading. One that I like is to have a technique for determining the trend of the market and then looking for opportunities in line with the trend. One of the problems of trading trend following strategies is that they generate frequent losses in non-trending markets. One way to mitigate this problem is to not trade the signals from your trend following strategy, but use them as a filter for your trades.

Lets say you use a moving average (or any other trend identification approach) to measure trends; instead of buying the market when it crosses the moving average, see it as a signal to look for buying opportunities. So your strategy is to be a buyer when the market is above the moving average and a seller when the market is below the moving average. You can then use any number of techniques for generating entry signals in line with the identified trend. If, for example, you are a fan of RSI or any other oscillator, use that as your entry signal, but only take signals in line with the trend as you see it.

When the market is trending, your trend following technique will keep you on the right side of the market and your entry signal is likely to produce multiple successful trades. When the market is range bound, you will still have the opportunity to trade profitably because you won't be trading every breakout, you will be naturally drawn to buying dips and selling rallies (in line with your trend strategy signals).

Malcolm Robinson