Thoughts on Technical Analysis

The wonderful thing with technical analysis is as Arthur Conan Doyle wrote in Sherlock Holmes and I quote

“It is a capital mistake to theorize before one has data. Insensibly one begins to twist facts to suit theories, instead of theories to suit facts.” 

Depending upon our perceived bias, its easier using technical analysis to get the outcome we desire. So, if I want to showcase why the markets may fall (though it may have been rising day in and day out), I would search for indicators that are showing overbought and since overbought in itself may not be a reason to sell, I will also check whether there is a divergence. Of course, once again, divergence is not a reason, but as long as it suits my view point, what the hell.

There exists a lot of bunkum when it comes to technical analysis, but when challenged, one key answer has always been, “it works for me, so there is something in it”. But its not that technical analysis is itself bunkum as many try to project since there exists ways and means to test a lot of theories and come out with valid observations that can be applied elsewhere too.

For example, while patterns are said to be in the eye of the beholder, there has been some serious amount of testing on the veracity as well as the success / failure of each of the patterns by Thomas Bulkowski who incorporated them in his wonderful book – The Encyclopedia of Chart Patterns. Hence while Chart Patterns are in itself subjective, one can guess the feasibility of such a pattern working or failing and hence applying suitable money management / position sizing algorithm to it.

But to me, the best systems are one where there is zero human discretion and charts are definitely not one of them. Once the human element is introduced, its easy to fall prey to try and fit the curve rather than the curve fitting the pattern on its own. 

To conclude, the next time someone claims to predict the market with the help of discretionary tools, do note that the possibility of his bias slipping into his analysis is pretty high and that distorts everything.