Options Trading For Dummies
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A few arguments against technical analysis may actually make some sense, but the irrelevant complaints far outweigh the legitimate. For example, some people wrongly assert that no technicians have been successful over the long run and that no technician has mustered the stature or success of illustrious market moguls like Warren Buffett, Benjamin Graham, or Peter Lynch.

As if to further this argument, they point to some infamous technician who blew up his portfolio in spectacular fashion. Then a few years later, they harp on another well‐known technician who made a boneheaded call, and then it happened again, and they therefore claim technical analysis is useless. Detractors usually leave out the fact that many high‐profile fundamental analysts have also blown client portfolios.

In fact, many successful technicians have long, profitable trading careers. While most toil in self‐imposed obscurity, some are prominent and outspoken.

For example, John W. Henry, who owns the Boston Red Sox, made his fortune as a trend‐following technician. Additional examples include Ed Seykota, a trader with 35 years of experience and one of the people profiled in the book Market Wizards, and Bill Dunn of Dunn Capital Management, Inc. This is just a tiny sample of the many successful independent traders and fund managers who employ technical‐analysis tools to make trading decisions.

Another argument about the alleged ineffectiveness of technical analysis is a chart‐reading challenge that no technician has ever attempted (or would even consider). It works like this: The technical analyst is given the first half of a price chart with all identifying information removed. From that information, the technician is supposed to tell whether the stock’s price was higher or lower at any point in the second half of the chart.

Of course, nobody ever claims the prize for having accomplished this feat, and that, therefore, is supposed to be proof that no technician ever has enough confidence in technical analysis to even try. Accomplished technicians aren’t any better at telling the future than a tarot‐card reader — and neither, for that matter, are fundamental analysts. Technical analysis is not fortune‐telling; it’s simply a trading tool.

Keep reading to examine arguments against a couple of the more common theories about why technical analysis doesn’t work.

Walking randomly

The random walk theory has nothing to do with hiking without a map, but instead is an academic theory that says stock prices are completely random. What happened to a stock yesterday has nothing to do with what happens to its price tomorrow.

Furthermore, this theory claims that the market is so efficient that consistently outperforming broad‐based market indexes is impossible. In other words, any edge that you may gain from fundamental analysis, technical analysis, or any other strategy is useless and expensive. After all, transaction costs far outweigh any performance improvement that your analysis provides.

Armed with computer models and reams of study results, academic experts cling to these efficient‐market hypotheses as gospel. Several challenges oppose their argument. No less an authority than the Federal Reserve Bank of New York published a study showing that using support and resistance levels improved trading results for several firms. Additionally, articles published in the Journal of Finance suggest that trading based on moving averages and head and shoulder reversal patterns outperformed the market averages.

Of course, these studies don’t prove that technical analysis is effective all the time. But they cast doubt on the validity of the random walk theory, especially the assertion that technical analysis can’t be used to consistently improve results compared to the market averages.

Debating these arguments to a logical conclusion is nearly impossible. Even when you use technical analysis successfully, random walkers claim your performance is the result of random chance — nothing more than good luck. Don’t believe them. Instead, believe that luck favors the prepared mind.

Trading signals known to all

Anyone who cares to look can see exactly the same patterns and has access to the same indicators as every other trader. So one argument against technical analysis is that there’s nothing new under the sun — or in the markets — for analysts to find.

Although some traders create proprietary indicators to gain a trading edge, many more use well‐known, off‐the‐shelf trading tools. Some are freely available on the Internet for anyone to use. Thus, if everyone sees the same thing, how can you use those trading signals profitably? The question is perfectly legitimate.

Although everyone can see the same patterns and indicators, this equality is a strength rather than a weakness. Technical analysis gives you insight into what future actions you can expect from your fellow market participants. With practice, you can use that information to construct a consistently profitable trading plan.

After you become familiar with traditional patterns and indicators, you can incorporate your experience and market knowledge into your trading plans and thus come to an understanding of when to use specific tools and when results are meaningless. From these plans, you can find out when a trading signal works and when it fails. You can make trades based on indicators and patterns that help and ignore the rest.

Many widely known indicators and trading patterns exist, but many successful traders use only a handful of the simplest ones. Your results will differ from ours. You may trade in a different time frame than others, or you may choose a different set of tools altogether. As long as your tools improve your trading, continue using them. Ultimately, your trading system should be like a fine suit, custom tailored to fit one specific person: you.

About This Article

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About the book author:

Dr. Joe Duarte is a financial ­writer, private investor and trader, and former money manager/president of River Willow Capital Management. In addition to Options Trading For Dummies, he is the author of Trading Futures For Dummies and Market Timing For Dummies. Visit his website at joeduarteinthemoneyoptions.com

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