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Yes, Give it to me

Does Technical Analysis Work? (It’s not what you think) 

 December 29, 2018

By  Rayner

I’m sure you’ve wondered…

“Does Technical Analysis work?”

“Is trading as simple as drawing a few lines on the chart?”

“Is Technical Analysis all I need to become a profitable trader?”

Now:

  1. You might say Yes because everything you need to know is on a price chart
  2. You might say No because you need to combine fundamentals, news, etc.

So, who’s right and who’s wrong?

Well, that’s what you’ll find out in today’s post (and it’s not what you think).

Or if you prefer, you can watch this training video below…

What is Technical Analysis and how does it work?

Technical Analysis refers to using past prices (or volume) to make your trading decisions.

This can be tools like candlestick patterns, chart patterns, technical indicators, trends, etc.

And this brings me to an important question…

Does Technical Analysis work?

First, how do you define whether Technical Analysis works, or not?

Here’s how…

  1. I’ll backtest a trading strategy using Technical Analysis
  2. Benchmark the results against a buy and hold approach on the S&P 500

Now…

If the trading strategy can beat a buy and hold approach, then we can conclude that Technical Analysis work (but more on that later).

So what’s the benchmark to beat?

If you look back historically, a buy and hold approach on the S&P 500 has a return of about 10% a year with a maximum drawdown of 56%.

Moving on…

How do you develop a trading strategy that beats the market?

Here’s how:

  1. Read research papers and find out what works in the financial markets
  2. Extract the trading strategy
  3. Develop your trading strategy
  4. Verify your trading strategy

Let me explain…

1. Read research papers and find out what works in the financial markets

There’s a huge resource at www.ssrn.com (and it’s free).

If you want some ideas, look up “momentum” and “value”, these are proven strategies that offer an edge in the markets.

The most important thing is to understand WHY a trading strategy works and the concepts behind it.

Don’t focus on the exact parameter like which is the best moving average, indicator, etc.

Those are not important.

2. Extract the trading strategy

Most research papers provide the trading strategy — and the backtest work is also done for you.

This means you can “copy” a strategy and it has a high degree of success.

3. Develop your trading strategy

If you’re lazy and don’t want to make any changes to the trading strategy, then move on to the next step.

But if you want to develop your own strategy, then here are some things to consider…

Now…

If you add too many rules, you might be curve fitting your strategy (to past data) and it’ll probably fail in the live markets.

Generally, the fewer rules you have, the better your strategy will work.

4. Verify your trading strategy

Never trust the results of other traders (no matter what).

You must always verify the strategy yourself so if anything goes wrong, you take 100% responsibility.

Now…

There are 2 ways you can verify your trading strategy.

You can either backtest it or forward test it in the live markets.

And I cover it in more details here: How to Backtest a Trading Strategy Even if You Don’t Know Coding

A trading strategy that works?

Now…

Using the concepts I shared with you earlier, let’s backtest a momentum trading strategy and see if it can beat the markets.

Here are the rules…

Buy rule:

Go long when a stock hits a 40-week high

Exit rule:

10% trailing stop loss

Filter:

Pick the top 20 stocks with the largest price increase over the last 40 weeks

Sometimes you’ll get too many stocks to choose from. So, a filter like this helps you select which stocks to trade.

Other parameters:

  • Transaction Costs: $10 per trade
  • Test universe: Russell 3000 stocks
  • Execution: Monday open
  • Maximum open positions: 20
  • Test period: 1990 – 2017
  • Positions size: 5%

Here’s an example of the trading setup…

Does technical analysis work

Moving on…

Trading strategy results

  • Number of trades: 4630
  • Winning rate: 45.83%
  • Profit factor: 1.5
  • Annual return: 23.47%
  • Maximum drawdown: 53.02%

And here’s the performance over the last 28 years…

Does technical analysis work

As you can see, this trading strategy has a higher annual return and a lower drawdown (compared to a buy and hold approach).

Overall, this is a simple strategy that beats the market.

And this brings me to an important question…

Is Technical Analysis all you need to become a profitable trader?

Some of you might say “YES” based on the results I’ve shared with you earlier.

Now, not so fast my young padawan.

Here’s why…

Yes, Technical Analysis can give you an edge in the markets.

But, it’s not enough to make you a profitable trader.

I’ll explain…

This is the ONE thing you need so your edge can play out

Recall:

Earlier, the trading strategy had a maximum drawdown of 53.02% — and this is with zero leverage.

Now, if a greedy trader decides to employ 2 times leverage, he’ll suffer more than a 100% drawdown and blow up his trading account.

Here’s another example…

There are two traders, John and Sally.

John is an aggressive trader and he risks 25% of his account on each trade.

Sally is a conservative trader and she risks 1% of her account on each trade.

Both adopt a trading strategy that wins 50% of the time with an average of 1:2 risk to reward.

Over the next 8 trades, the outcomes are Lose Lose Lose Lose Lose Win Win Win Win.

Here’s the outcome for John:

-25% -25% – 25% – 25% = BLOW UP

Here’s the outcome for Sally:

-1% -1% -1% -1% +2% +2% +2% +2% = +4%

So here’s the lesson:

If you don’t have proper risk management, you’ll still end up a losing trader even though you have an edge in the markets.

Do you have what it takes?

If you look at the results below, you’ll notice there are losing streaks that can last for many months.

And sometimes, the drawdown can be as much as 20%…

Does technical analysis work

Now let me ask you:

Are you prepared to handle the losing streak when it comes?

Because you can have an edge and proper risk management but, without the “strength” to endure the drawdown, it’s impossible to be a consistently profitable trader.

Clearly, your trading psychology is important (and too many traders neglect it).

If you want to improve your mental strength, then go read Trading Psychology: 6 Practical Tips to Master Your Mind and Money

Conclusion: Does Technical Analysis work?

Yes, Technical Analysis works and it can give you an edge in the markets.

However, Technical Analysis alone is not enough to become a profitable trader.

You must have:

If you lack any one of them, then it’s impossible to find success in the markets.

Now, here’s what I like to know…

Does Technical Analysis work for you?

Leave a comment below and share your thoughts with me.

  • Yes but as you said I only risk one percent of my account but I need to work on overhearing and stick to the rules of entry I have made up a strategy of my own and it works well but while trading I will experiment a little with it JUST TO SEE if it works better fortunately I do this only on a demo account lol

  • There is never any verifiable data in these type of “selling a dream” strategies. They are all about getting you to pay the person publishing the idea.
    If they were successful then there would be more verifiable data.

  • To be honest, I’m not the best backtester. I see what is happening in the market, think “yes ican do that”, then chicken out because the market is giving me mixed messages. E.g. the market reaches a support level and goes through and looks like a breakout. I goto sell the market and second guess myself “should I sell now, because it might reverse back through the support, or should I wait to see if it will go through a few days and bounce back up to the now resistance level before heading back down. I have missed multiple trades this way. I seem to have too many mixed messages from the market, or just lack confidence.

    • Thank you for sharing, Michael.

      It’s best to define your strategy first, and then backtest or forward test it.

      Once you’re confident it has an edge, then it’s a matter of execution without hesitation.

      cheers

  • actually, i am somehow new in the forex world, trying very hard to develop a strategy that works after almost blowing up my first account. i believe in technical analysis base of on what have discovered so far from my study and research tho am yet to test run my strategy. but how can one combine technical analysis and fundamental analysis at the same time, is it possible?

  • Hi Rayner

    I totally agree with what you said about having a strategy.

    I always tell the traders I help out and mentor that they need to develop a rule based trading strategy which works for THEM and makes THEM money NOT what someone else is doing. Remember, what works for one trader mostly likely WILL NOT work for another, why, because everyone’s risk appetite is different.

    I hope this helps

    Good luck with your trading and investing and remember: Trade smart…OR JUST DON’T TRADE!

    Stock Trading Blogger

  • Thank you Rayner, I trade Pinbar/Engulfing strategies, with ice cold risk management of fixed dollar amount per trade, I give my trade time to play out to either proof me wrong or make me money. Thank you for your numerous lessons.

  • i was a normal swing trader and learning all info along the way, i started to profit when step into the 3 year, the thing that changes my negative to positive is when i started to really follow the discipline and sticking to my trading rules, i guess sticking to your rules is my edge, happy trading everyone.

  • Technical analysis works, but not in totality, because news releases tend to create certain movements that invalidate conclusions drawn from technical analysis.

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