Tuesday, October 16, 2007

The Secret of Technical Analysis

I understand technical analysis to be any method that attempts to predict market moves based on past price and volume action rather than fundamentals. This includes the use of charts and also more sophisticated modelling. Most finance academics believe that securities follow simple random walk paths and technical analysis cannot predict anything. Now, much technical analysis probably isn't much use, its practitioners haven't tested the trading results based on it in a statistically valid way. The reason many traders probably make money is the use of stops. They stop their losing trades before they lose too much and let the winners run. Trend following approaches are similar. You will hear this advice very often when you start to study trading. In this case entry points can be more or less random. The profit-making assymetry is all in the stops.

In the last few days I've been researching various ideas I've had for improving my trading models. So far I haven't found anything better than I'm currently using. Some of the models fit the data better but aren't any better for trading. In fact they are worse. This is the secret. Models that fit the data well and have high levels of statistical validity are often not much use for trading. The type of models that no self respecting econometrician would choose are actually the best for trading purposes. This a major reason why academic finance rejects technical analysis in my opinion. The models they optimize to the data aren't actually useful for trading. But it is non-optimal models that can actually generate profits.

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