Trading Systems
and Technical Analysis Indicators
All forecasts are wrong!
They differ in the extend of their wrongness,
and it is usually possible to improve any forecast by gathering further relevant information
or by processing in a more elaborate way, what is already known.
This costs money and time,
the expenditure of which can only be justified if greater benefits can be obtained.
Technical analysis looks at the relationships that exist between a stock's price,
its volume (the number of shares that trade hands during a single day), and other factors.
By using plotting and various mathematical models and analysis,
technical analysts hope to be able to predict future changes in the price of a particular stock.
By looking for particular patterns on a price chart of a stock, for instance,
technical analysts try to figure out the direction that the stock's price is likely to move in the future.
Many new traders have a tendency to confuse trading systems and technical analysis indicators.
The majority of the confusion comes in the form of confusing the use of technical analysis indicators with systems.
Technical Analysis Indicators
A technical analysis indicator is used to determine the trend of a market,
the strength of the market and the direction of the market.
A technical analysis indicator may be specific or non-specific.
Some technical analysis indicators can be quantified in the form of an equation or algorithm.
Others show up as patterns (e.g. head and shoulders, trendlines, support and resistance).
At some point, the technical analyst will receive a signal.
This signal is the result of one technical analysis indicator
or more than one technical analysis indicators in combination.
The signal indicates to the technical analyst a course of action (e.g. buy, sell, hold).
The technical analyst will determine the method to use.
However, it must be specific, objective, and reliable.
The method is a subjective and not mechanical.
This is a significant difference between a trading system and a technical analysis indicator.
Anyone with an imagination can create a technical analysis indicator.
Everyday at least one new technical analysis indicator is created.
Over the years thousands have come and gone.
Most of them don't tell us anything about the market.
They're useless. Many others are of no use whatsoever.
Timing indicators tend to work in some types of markets
(e.g. trending or sideways) and not others.
They may also work with some securities and not others.
Therefore, they tend to be unreliable.
Timing indicators are also subjective and require interpretation.
Based on my experience, most amateur traders tend to use timing indicators
and base their decisions to buy, sell, or hold on them.
Many traders, after using an indicator or indicators with success
turn them into a trading system.
This does not mean that the trader has found the holy grail of trading systems.
Instead, what many traders find is that when the indicators are combined
into a trading system, they lose their effectiveness.
Technical Analysis Trading Systems
A trading system is created by generating signals, setting up a decision making procedure,
and incorporating risk management into the system.
A trading system is supposed to be objective and mechanical.
The analyst combines a set of objective trading rules (usually in a formula or algorithm).
As a general rule, good technical analysis indicators
are the building blocks of good trading systems.
However, as previously mentioned, even good technical analysis indicators
can lose their validity when combined in a trading system.
Therefore, it is important to not only back-test your system
but to also forward-test your system in real time.
Pitfalls of Trading Systems and Technical Analysis Indicators
Trading systems are supposed to be objective and mechanical.
They take the intuition out of trading.
Buy when the system tells you to and sell when the system tells you to.
The problem is that there are not a lot of good trading systems out there.
However, some are created for certain institutions
to take advantage of arbitrage opportunities, or tricky derivative strategies.
They are not at all suitable for the average trader.
Traders tend to lose objectivity when using technical analysis indicators.
The trader is not able to remain objective
and the subjectivity of using the indicator overwhelms him.
I think it has to do with a compulsion many traders feel to have to trade.
They then tend to subvert their indicators by trading when the signal is not entirely clear.
Traders have a tendency to test their trading systems and technical analysis indicators
on an insufficient amount of data.
Analysts need to test trading systems and technical analysis indicators
on a wide array of data in different types of trading markets.
Additionally, many traders and analysts don't forward test their trading systems
and technical analysis indicators in real time.
They rush to trade based on insufficient back-testing and forward-testing.
Thus, they are trading on not a sound, valid basis.
Many traders fail to incorporate sound risk management techniques in their trading systems.
Additionally, many traders fail to incorporate stop loss orders
with their initial orders when using technical analysis indicators only.
Traders also tend to over-optimize their trading systems.
They start asking the what-if question and back-test the trading system
with different parameters.
They are always trying to trade with the parameters which generate the highest
amount of wins.
However, in real time these over-optimized systems rarely perform well.
Another trap traders fall into is to use too many technical analysis indicators.
Find the few that work consistently well for you and go with them.
I find the time tested technical analysis indicators to be the best.
Conclusions:
I have always considered speculative trading more of an art than a science.
The best traders I've ever seen use technical analysis indicators and intuition.
However, despite their intuition,
one thing common to all of them is that
whether they can articulate them or not,
they all have a set of well defined rules they trade by.
If you are considering buying technical analysis software
be very skeptical of systems that advertise tremendous results.
They have probably been over-optimized to show excellent back-tested results
and won't work when you try to use them.
Of course the company will have a whole list of reasons why it isn't
working well at that particular point in time!
However, excuses don't do you any good when you're losing hard earned money!
Last, what works for one trader may not work for another trader.
If it works for you - that's all that counts!
