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?”
- You might say Yes because everything you need to know is on a price chart
- 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.
And this brings me to an important question…
Does Technical Analysis work?
First, how do you define whether Technical Analysis works, or not?
- I’ll backtest a trading strategy using Technical Analysis
- Benchmark the results against a buy and hold approach on the S&P 500
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%.
How do you develop a trading strategy that beats the market?
- Read research papers and find out what works in the financial markets
- Extract the trading strategy
- Develop your trading strategy
- 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…
- Entry criteria
- Exit criteria
- Trend filter
- Risk management
- Markets to trade
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.
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?
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…
Go long when a stock hits a 40-week high
10% trailing stop loss
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.
- 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…
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…
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.
Yes, Technical Analysis can give you an edge in the markets.
But, it’s not enough to make you a profitable trader.
This is the ONE thing you need so your edge can play out
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%…
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.