Uncategorized | Portfolio Yoga

The Wake up Call for Technical Analysis

Technical Analysis has never been seen as a viable tool for generating income / wealth from the markets and the number of jokes surrounding that are legion to say the least. The Oracle of Omaha once said and I quote ”

“I realized technical analysis didn’t work when I turned the charts upside down and didn’t get a different answer.”

While I have no clue as to what chart he saw before making such a comment, I am very sure that if he saw any trending chart, there has to be a different answer if you were to invert the chart.

Today, Technical Analysis made its mark in Dilbert and once again seemed to suggest that technical analysis is no more than Sorcery mixed with Astrology. Before I continue on my tirade, here is the cartoon strip that will remain famous for years to come

One may recall that when Gold saw a steep fall, some one created a chart and aptly named it “Vomiting Camel” pattern. While no technical analysis books carry any details of any such pattern, with one hearing about all kinds of animal patterns, this was not entirely surprising to say the least.

While every strategy, be it quantitative or value investing has its faults, when it comes to technical analysis, one feels that maybe we are beyond reproach. Most doctors consider Homeopathy to be equal to quack medicine though I can line up persons who have been treated successfully, critics are happy to point out that its nothing more than sugar pills that are seemingly disguised as medicine. The act of curing is purely based on our mental strength and this serves only as a Placebo and in a way acts as a catalyst to cure the problem being faced.

The reason Allopathic medicine is not only widespread but also widely used is due to the fact that to qualify as medicine, it has to go through several tests (including blind tests) which try to ensure that the medicine is really effective without the healing happening due to other factors. How many of our Ayurvedic / Homeopathic / Unani based medicine can claim to have such strong test requirements?

Just today, I read that the Government of Telangana Chief Minister saying that it will construct a new secretariat building in Hyderabad since the existing one suffers from Vastu defect. Before you laugh at the ridiculousness of the thought process, do give a thought to the many who claim to have seen changes in their life owning to they shifting the door / window / bathroom / pooja room. You name it and you can find plenty of people whose lives have changed. So, should we start teaching Vastu along with Architecture?

On Google, a search for Technical Analysis is provides one with the following options

Think about it for a second. A way of investing / trading is seen more as something that does not work than something which is a way to investing. Even the second option has reared its head only recently.

I am a strong believer that technical analysis works. Even though Quantitative Analysts would want you to believe that the difference between Quantitative Analysis and Technical Analysis is similar to the difference between Astronomy and Astrology, I strongly differ for the simple reason that not only are a lot of concepts have its foundation in mathematics, a lot can actually be proved much to the dismay of its opponents. Its only recently that researchers have agreed that Momentum in markets are sustainable and can be used to generate returns above what Beta says they would.

While Fundamental Analysts strongly believe in valuing the business, we Technical Analysts strongly believe that human psychology has not changed and hence patterns keep repeating the way it has done for hundreds of years now. We believe that finally, Price is King since there is no point in disagreeing with a price that the market believes to be the true value of a stock / index.

That said, the bane of technical analysis lies in patterns / strategies that seemingly cannot be expressed in mathematical terms and hard coded so as to be able to apply it without the need for a chart.

If you look at the sky, its easy to see patterns in clouds though they are nothing more than random elements coming together to play a trick on our minds. Why is it so difficult to accept then that many a pattern that appears on charts are no more than the coming together of random elements.

A lot of patterns can be hard coded and tested for efficiency and these to me are worth pursuing (if the results when tested blindly on multiple markets yield similar kind of results). In fact, a lot of hedge funds are rumored to use pattern search algorithms in order to squeeze out gains from seemingly random movements in markets.

But not all patterns / strategies are the same and if you believe that the strategy you pursue can never be coded & automated fully, you are failing to distinguish between the real and dream.

The Church for a long time held steadfast to its belief that the Earth was the center of the Universe before finally acknowledging the universally known and acknowledged truth. Similarly, Technical Analysis if it wants recognition and respect needs to accept that there are strategies that can be tested and proven as viable and there are those that are good for selling newsletters and does not actually fulfill the promises it makes about its ability to predict into the future.

Technical Analysis is to me is more than just a way to get probabilities better than what can be achieved using a simple coin toss. We may never get a Technical Analyst with the stature of Warren Buffett but we do have folks like Dunn Capital who have shown strong performance for a very long period of time. I strongly believe it makes sense to learn what CTA’s use for developing their trading models since many of them have shown handsome market beating returns without having to buy stocks / companies.

I strongly believe that long term wealth can be generated using strategies based on the concept of technical analysis. But always have a skeptical mind since its better to be seen as stupid for asking a question than seen as a stupid for having lost money using a strategy that can hold no water.

Let me end here by quoting David Hume from his book, An Enquiry Concerning Human Understanding

“In our reasonings concerning matter of fact, there are all imaginable degrees of assurance, from the highest certainty to the lowest species of moral evidence. A wise man, therefore, proportions his belief to the evidence.”

Support, Resistances and Trend Following

Support and Resistances are the key tools of technical analysts who rely on the chart for making their assumptions. The key concept here is that of human psychology. A support is a place where the markets have made a bullish reversal earlier and one where one can expect fresh buying to come in and a resistance is a point where the price had taken a bearish reversal and hence when the markets came back to the same point next time around, you should see some amount of selling.

Rather than re-write what has been written in multiple books, I shall instead reproduce here what Jeremy Du Plessis writes in his authoratitive book on Point and Figure.

The price is in a downtrend. It pauses, reacts back up to point A, and then falls to point B.Technical Analysts do not reason why it did this; it is simply understood that supply and demand caused the price to move in this way. At point A, buyers were not prepared to pay any more and so the price declined to B, where the buyers were prepared to start buying again.

You have to remember that the market is made up of lots of participants with differing views and obj ectives. Buyers who bought at point B may take profits at point C. However, there is another group who bought at point A, are pleased that the price has risen back to the same level at point C, and are pleased to get out of their position. This collective view causes a resistance level at point C and causes the price to move down from point C.

Remember, buyers at point B made a good gain when they sold at point C, and so when itgets down to point D they start buying again. This creates a support level, where buyers are prepared to take an interest again. This demand pushes the price back up again. Once again, at point E, they start selling, reinforcing the resistance level at that level. This causes the priceto decline again until it reaches support at point F, where the same short-term traders, who have bought at B and D before, start buying again.

Point G is as far as the price gets again because the short-term traders have become confident that it will not go higher, and so the resistance at that level gets stronger. It declines again to point H and, once again, the buyers come back again, creating support for the price. The price bounces to point I and then falls back to point J. The same buyers who bought at point H are pleased that they now have a second chance to buy at the same price at point J, but this time, the sellers are in charge and force the price below point J. It is important to consider how the participants feel about this. Buyers had become confident buying at the same level and
making a profit, so much so, that they probably were buying increasingly more each time.

For the first time, they are in a losing position. Some will sell their positions immediately, creating a selling frenzy that pushes the price down. Others will, however, hope and pray that the price will rise back to the price they paid. Point K is the point where the price has become oversold. That is, it has fallen too far too quickly, and short-term traders looking for a quick profit start buying. This forces the price back up to point L briefly, where the new buyers take a quick profit and some of the B, D, F,H and J buyers sell to break even. The move to point L is short-lived as so many sellers appear. So, the level at point L, which was a support level, now becomes a resistance level.The price falls to point M.

There is no reason why the price stops at point M. It could be at any level. It is simply a point where demand exceeds supply and the price is driven back up again. It is important to pause and consider the psychological make-up of the participants. There will be a large group who bought at the B, D, F, H and J levels and are still holding their positions. What is going through their minds is ‘if only the price can reach the price I paid, I will sell out and never buy another thing again’ ! This creates even more resistance at the L level, which is the same level as the previous support. So, when the price does eventually rise back to that level, those who have been praying start selling at point N, reinforcing the resistance level and forcing the price down again to point or lower. The level at points L and N will remain a strong resistance until there are no sellers left at that level.

The important point about this scenario is to understand that levels of support and resistance do occur on charts and that they occur for psychological, not fundamental reasons. When support is broken, it is important to recognise and understand that support becomes resistance to any up movement and that this is also caused by psychological reasons. Although not shown in the diagram, resistance, once broken becomes support to any down movement. So support and resistance alternate.

Trend following on the other hand does not concern with Supports and Resistances as those defined in the chart above. What Trend following looks for is a reversal of the current trend. So, at none of the points mentioned does a trend follower get a signal to reverse his existing position.

Trend following is always a late comer since it first waits for evidence of the fact that the trend has really turned around to Bullish / Bearish. Only once the confirmation (based on whatever approach you have), does one get a signal to reverse the signals and bet on markets moving the other way.

When you assume markets to reverse from a support or resistance point, you are in affect claiming the power of prediction where none exists. At any resistance / support level, what is the probability of a reversal happening? I would say its 50-50. It may happen, It may not. But if the whole probability is just 50%, why are Support / Resistance lines looked upon with such flavor?

The reason in my view is that this happens due to the fact that we see what we want to see. Lets use a real example, the Daily chart of Nifty.

I have marked all previous tops as they occurred. As you can seem only once or twice was the next low in line with the previous top. Most times, it made a low where there is theoretically no supports or made a high where there was no resistance (the Dotted line for instance).

Markets being a game of probabilities, do you really want to go with nothing but a theory that is seen as good just because we can find evidences of it working (Selection Bias anyone?).

Nowadays everyone calls himself a trend follower as trend following has become the faith to be seen in (just like all folks on the fundamental investing side want to be seen as Value Investing, even when they are investing in stocks like Bosch 😉 ), but true trend followers never trade based on rules that cannot be tested historically using a automated program.

After all, its well known that the mind has the ability to see patterns where none exist and similarly, we are adept at seeing support and resistances where they worked while if you were to codify it, you shall see that its a strategy that does not have a Edge.

Nowadays I am starting to agree with the philosophy of “Whatever Works”. If it works for you great, but do remember not to confuse strategies just because some one says they are one and the same.

The reason Asrtrology / Vastu and even Homeopathy is looked down upon is not because it has not been proven to be right ever. Search enough and you shall spot enough folks who shall swear by it. The reason why they are not accepted by the scientific community is due to the fact that they cannot pass tests designed to remove the human bias and behavior pattern for instance.

In Technical Analysis, unless you remove the bias of the self, any pattern / any strategy can be seen as one with excellent characters where none may exist. In a way, its amazing that while we understand the reason why lottery ticket buying is a waste of money given the low probabilities of it working for us, we fail to reason out similarly low probability strategies that are abound in the market.

Until you are able to sieve the wheat from the chaff, the results will always be sub-par – something that you could have got without having to go into all that trouble in the first instance. Food for though. eh? 🙂

Stick to what we know best

Many a time, On my way to Office and on my way to Home, I come across daredevils who ride their vehicles as if they are in a Moto-GP race. While most onlookers either shake their heads or just ignore them, there are a few young guns who get influenced and attempt to compete with them, either straightaway or when riding with their friends.

More often than not, most speeding drivers finally end up in a hospital or get fined by the police and in worse case end up in Mortuary. Even the rider knows the risks he is getting into, but as they say, Speed Trills (as long as it does not Kill).

So, what is the relationship with markets you may ask. Sitting in a Air Conditioned cabin, one feels that there is a very low risk of getting physically hurt let alone die because of acts of omission and commission. But financial destruction is also a form of death, a slow death by a thousand cuts perhaps, but death for sure if one continues to tread on the wrong line regardless of the hundreds of pointers showing one is on the wrong side of the road.

Yesterday I was talking with a friend of mine about the legendary trader, Jesse Livermore. No matter what his greatness lie, the true fact is that he died a broken man. Broken both in terms of his mind and financially. While its nice to see the positives on one’s life, I wonder how many have given a thought that even the best trader (perhaps) finally ended up broke. He blew his capital not once or twice but four times (and officially declared Bankruptcy twice).

A wonderful quote from Jesse goes as thus

The game of speculation is the most uniformly fascinating game in the world. But it is not a game for the stupid, the mentally lazy, the person of inferior emotional balance, or the get-rich-quick adventurer. They will die poor.

While we do not floor the accelerator just because we see some one race past us, why is that we do not think before acting on some one else’s thought. Yesterday I read a article which claimed that Anonymous Analysts were wreaking havoc in a few stocks by giving Sell calls without there being much of data to back them up.

When some one cries Fire in a crowded theater, the instant reaction is to rush to the exits without bothering to check whether the fire is real or not. The reason for the rush is that one is ill prepared to know whether there is a fire or not and would rather be found foolish to rush with the crowd than face the ignominy of being unable to escape just because of not acting fast (if there was really a fire).

In markets though, its a fact that Herds are both right and wrong. Right most of the time but wrong at the extremes. But if you are part of the herd, the end result will be one of failure since you cannot judge when they are right and when they are wrong.

Most Analysts (and you can include me as well 🙂 ) do not have a clue. While many of us work on probability, some just throw spaghetti on the wall and hope that some thing sticks. And then there are those who cry wolf every time the market dips a bit – the perma bears whose only hope is to claim that they in fact managed to catch the top.

Markets are a great vehicle for building long term wealth. If you were to Analyze the 140+ years of data (200+ from some sources) that is available for the US markets, you shall see that even those who were unfortunate to enter at the height of the market were able to generate more returns over time than what investing into safer assets (such as Bonds) at the same time would have returned.

But the key to building long term wealth is having a plan and having the balls to stick with it through thick and thin. If you are riding a Hero Splendor, do you worry about trying to compete with the Honda Hayabusa? If no, why worry about the noise generated by others who at best can misguide you on your journey and at worst derail your long term growth.

If you were patient enough to read through my long rant, I am sure that you can stick to your plan.

au revoir

January Barometer

I am currently reading the much acclaimed “Stock Trader’s Almanac 2015” and the first major seasonal indicator that comes up for discussion is the January Barometer. Designed by Yale Hirsch in 1972, the January Barometer states that as S&P 500 goes in January so goes the year. The Indicator has been successful 89.1% of the time since 1950.

In India, we are not fortunate to have such large data sets and hence I have had to make do with the Sensex data that I have. Starting from 1982 till 2014, the Sensex has had a record that is pretty close to a coin toss.

In those 33 instances, markets have followed January only 17 times while going against what was seen in January 16 times. In that sense, there is nothing much to take from it. But with January 2015 being +ve, let us see what it can bring in the year ahead.

Of the 16 times January has been positive, the year has ended in positive territory 12 times. That is a nice 70% hit rate. The average gain for the year in such years has been 31.81%.

In the 4 instances where January was +ve and yet the year closed on a negative note, the average loss in those years came to 13.69%

On the other hand, what if January was Negative? We have had 17 such instances and of those, January affect was seen in just 5 years (January negative and Year ending in Negative).

The average gain for the year when January was negative (12 instances) came to a astounding 36.86% whereas the average loss of the year when January was negative (5 instances) came to 23% (a reason for the high loss being 2008 when markets fell 52%. Exclude that and the average drops to 15%).

Since January 2015 ended with gains, right now the higher probability is of markets to close in +ve territory. Then again, this is neither a wholesome trading strategy nor do we have a very high confidence level.

What does one want from the markets

Win or lose, everybody gets what they want out of the market. Some people seem to like to lose, so they win by losing money – Ed Seykota

A very simple statement yet so deep is the philosophy behind it. Its amazing that I did not understand the depth of the statement when I went about showcasing why certain strategies / methods were not worth pursuing since the cost out weighed the benefits it supposedly came up with.

Then again, I failed to understand that not everyone is out here in the markets to make the maximum out of it. A large majority is here for the fun and if some money is made in the interim, all the better. But a very small percentage is ever going to wonder if I made a better CAGR return out here compared to the opportunities available elsewhere in markets (read Passive Investing).

Day trading is a very risky business with the probability of long term success reaching pretty close to the Zero level. But that does not stop the troops of young and old speculators who want to dabble in it. Many are not even here for the money since they have money in plenty, all they are looking for is the excitement of being able to beat the markets at its own game.

I know friends who are pretty happy with getting returns that have been achieved by many a fund and more or less achieved by passive investing as well. But, if you were to invest passively and reap the benefits, how the hell are you supposed to look like the King Kong of markets at parties where you want to be the Rock Star. After all, its only a dumb guy who would invest in Mutual Funds / ETF’s and reap the small benefits when the same is also available by trading day in and day out in the markets.

A lot of traders / investors have lost big money in markets and yet go about their life pretty happy with the sincere belief that it was Greece or Cyprus or Japan (or any other news) that was the reason for their loss this day / month / year and its just a matter of time before they not only recover their losses but thrive in the limelight of being the true master of the universe.

Markets are all about give and take. If you are here for building wealth, think deeply about what you are doing and whether some things can be done better. If you are here for the fun, Enjoy as long as your Bank Account is able to support. But whatever you do, do not mix the fun part with the wealth building part. It will only end badly and you would not even had the fun in the interim

The one minute Challenge

A systematic trader faces several dilemmas when he is trying to figure out the best time frame he should use. Should he go with a 5 / 15 minute bar where he will get a lot of signals or should he chose the 60 / 120 minute bar where signals are far less.

For those trading the hourly / 120 minute bar, a secondary question arises. Should his bar start at 9:00 in the morning (even though trading starts at 9:15) and hence have his first hourly bar reflecting 45 minutes and the last hourly bar reflecting last 30 minutes of trade or should he start his bar construction at 9:15 in which case, he will have to deal with the problem of having his last hourly bar of just 15 minute duration (3:15 to 3:30).

A optimal solution recommended for the Indian market scenario is to have 75 minutes and start bar construction at 3:30. This way, all bars are uniform in nature. But 75 minutes is not exactly something you come across in any technical literature. Its just a number that is at the current moment the best way to divide the Indian Market timings into equal number of bars.

While you may wonder as to why such small difference as important, a simple back-test shows how varied the results are for the various time frames and the difference based on the starting bar.

Lets take a simple 3 EMA by 5 EMA system (trade price being the close price) and see how much of a impact the starting time will make to the overall returns. Test period is from 0.1.01.2010 to 31.12.2014 – Nifty Rolling Futures

As you can see, its more or less evenly split. For the 30 minute bar and the hourly bar, backtesting seems to indicate that using 9:00 as the starting time frame would be best suited. On the other hand, if you were using the 75 minute or the 120 minute bar, using 9:15 would be the way to go.

Now, let me complicate things a bit. Should your bar start at 00:00 or 00:01. For example, should the bar reflecting the data between 10:00 – 11:00 start at 10:00:00 & hence end at 10:59:59 or should it start at 10:01:00 and end at 11:00:59 ??

You think I am kidding, well lets take a look at results, shall we

If you are a trader using 30 minute bar or the 120 minute bar, the difference is staggering to say the least. Its no kidding matter to see your results poorer by 32% just because you chose to move the time by 1 fricking minute.

Intraday trading (even of the positional variety outlined above) is tough and its no small matter as to how small changes in where the bar starts, where the bar ends and how long a bar should represent can dramatically vary the end results. Reminds me of the Butterfly effect.

So, what is the solution? Unfortunately, there is no easy way out. You may think that using End of the Day bar can eliminate such things, Right? Well, most systems that are tested on End of Day time frame use the adjusted close and good luck on being able to get in and out at the adjusted close prices. As to those who use Open of next day, you will need a co-located Algorithm system to even be able to come close to buying / selling at those prices.

The idea of this post was not to showcase what is right and what is wrong, but to provide you with data to show how small things can make major differences and hence the next time you think about extrapolating something, do keep this in mind.

A New Kind of Investment Outlook

A very good “Long Read”. Lot of Wisdom out here.

Share this:

Share this:

Share this:

Share this:

Share this:

Share this:

Share this: