Technical Analysis Difficulties: Significance Matters

Exploring The Various Psychological Reasons Behind Technical Analysis Difficulties

One Reason Why Technical Analysis Is So Difficult

When you show a stock chart to 10 different analysts you are more than likely to see 10 different conclusions about where it is going. Yes, technical analysis is difficult not only because of the mountain of tools and indicators involved but to make things even harder, the psychology of the person performing the technical analysis makes a huge difference as well! In fact, two persons employing the exact same indicators and tools look at the exact same chart on the exact same time frame is more than likely going to have two different conclusions! One of the factors that makes technical analysis so difficult for beginners is determining the level of SIGNIFICANCE of what a technical indicator is showing you.

The Myth of Objective Technical Analysis

Technical analysis has been marketed and taught the wrong way for a very long time. It has been taught and marketed as an precise science where buy or sell decisions trigger on objective black and white price targets and technical triggers. So, most beginners to technical analysis go away with the idea that as long as the price crosses this line or when this line crosses that line, a trigger to action happens. In fact, so rooted is such wrong idea that an entire industry of so called "quantitative trading" or "robot trading" or "algorithmic trading" has been created where computers take the place of a real human trader and simply executed trades based on the triggers of black and white formulas. In fact, there was a time around the dot com crash of 2000 when hedge fund companies hired more of these so called "quants", who are simply computer science guys making computer programs and formulas, rather than real finance trained traders. More than 20 years after the advent of such methods and still we are no closer to the "holy grail" and no 100% winning robot has been created. Why is that so?

The reason is that each technical indicator that is triggered requires an additional subjective analysis of its SIGNIFICANCE within the context of the overall market and trend! This is what is missing in black and white formula and why technical analysis is so hard to understand for beginners who expect that as long as one line crosses another, the stock price must drop or rally.

The Role of Significance in Technical Analysis

So, what is the meaning of significance in technical analysis? The concept of "Significance" comes as a natural one for an accountant as "significance analysis" is something all accountants and auditors have to be familiar with in order to come to a conclusion about the condition of a company through its financial statements. Just the black and white numbers will not do and this is something well understood in the accounting industry. However, this is the same mindset and system that must apply in technical analysis which is sorely missing by most technical analysts whether beginner or experienced.

What do I mean? Here is a simple illustration of this principle. If Stock Price > 30MA = Bullish Long Signal. Now, lets say the 30MA is at $100 and the stock moved to $100.01. This is when algorithms will trigger a buy and when most technical analysts will also buy into the stock. However, consider this, is just being $0.01 above a line that is simply an average price of the last 30 days such a significant event that warrants an investment decision? What if the stock is $0.01 lesser than that line at $99.99 then? What about $0.01 that makes the difference between a buy decision or not? Where then do we "draw the line"?

Do you see the problem now?

There is nothing magical about that 30MA line, it is just a graphic representation of a mathematical formula. What is it about that line that makes such a big difference being $0.01 above or below? Is being $0.01 above the line SIGNIFICANT enough to trigger the investment decision? This is when all technical analysts need to take the extra step, a step most technical analysts do not bother with these days, of understanding the whole logic of why being above the 30MA signals a buy in the first place. In this simplistic scenario, we need to understand the exact formula that creates that line on the screen and then examine the underlying logic of why being above that line warrants a buy decision. This is the proper way of conducting technical analysis and understanding the significance of a signal trigger. So, in this simple scenario, the line is merely the average of the last 30 days prices. Being above the line means that the stock is trading at a higher price than the average of the last 30 days. Thats all it is saying. So, as an investor you now need to decide based on this logic, how much above that line then is significant enough to call a buy under this logic? Is being merely $0.01 or $0.10 above the average price of the last 30 days SIGNIFICANT enough to call a buy or buy a call?

Applying Significance in Technical Analysis

As you can see from the simplistic example above, just fulfilling the condition of the technical indicator rule is not a good enough or reasonable enough reason to simply justify a buy action. When technical analysis tools are used this way, it becomes what I call "Technical Analysis Superstition" that somehow as long as the price is above the line, it magically means the stock price is going to go upwards without any real understanding of the reasons and therefore the significance of such a trigger.

However, the tricky thing is that SIGNIFICANCE is going to be different for each technical analysis tool that you use and in most cases, even if you define what is a significant enough trigger, grey areas still exist. For example, since $0.01 above the line is not a significant enough break to justify a buy action, the trader now extends the rule to being at least $0.50 above the 30MA line as a significant enough move to justify a buy action. In this case, how about $0.49 above then? What about the $0.01 difference between $0.49 and $0.50 that makes $0.50 a buy? See where I am going with this now? This means that ultimately, a human trader is indispensible from the decision making. A robot trading a fixed algorithm may not have entered into the position at $0.49 but a human who has determined that $0.49 is significantly close enough to the $0.50 point may execute the buy action. Of even greater consequence is a rule saying to sell at the "$0.50 ceiling", a human trader would deem getting to $0.49 significant enough and sold out of the position before it dropped while a robot would have held on to it and dropped with it.

Again, this is only a simplistic example. What is a SIGNIFICANT fulfillment of the technical trigger is going to be different based upon the exact formula of the technical indicators used, the net effect of all the technical indicators being used, the historical behavior of the stock in question, the overall trend framework the stock is in and more. This is again why a fixed algorithmic rule is never going to overcome this problem in technical analysis and why that industry still has not produced the 100% winning robot and why it simply CANNOT.

As such, the next time you perform technical analysis, bear this factor in mind before you execute a buy or sell action based on a technical trigger... ask yourself, "Is this Significant enough?".