Pitfalls of Technical Analysis when Day Trading - dummies

Pitfalls of Technical Analysis when Day Trading

A lot of people make a lot of money selling services to day traders. They produce videos, organize seminars, and (ahem) write books to tell you how to be a success. But in the financial world, success is a combination of luck, skill, and smarts.

Before you commit wholeheartedly to any particular school of research and before you plunk down a lot of money for some “proven” system demonstrated on an infomercial, think about who are you are and what you are trying to do. Despite all the books and all the seminars and all the business-school debates, every form of research has its drawbacks. Keep them in mind as you develop your day-trading business plan.

If it’s obvious, there’s no opportunity

Many day trading systems work much of the time. For example, a security gaps up, meaning that, due to positive news or high demand, the price jumps from one trade to the next. This is good, and the security is likely to keep going up. So you buy the security, you make money. Bingo!

But here’s the thing: Everyone is looking at that gap, everyone is assuming that the stock will go up, so everyone buys, and that bids up the security. The profit opportunity is gone. So maybe you’re better off going short? Or avoiding the situation entirely? Who knows?

And that’s the problem. Looking for obvious patterns like gaps tells you a lot about what is happening in the market, but only your own judgment and experience can tell you what the next move should be.

Overanalyzing the data

Sitcoms always revert to tired formulas. The smart kid brags about how he or she will dominate a talent or quiz show, but panics on the big day. Two people who can’t stand each other get a horrible sickness that requires them to be quarantined — in the same hospital ward.

Or there’s this one: The kids want to do something that the parents don’t approve of. The parents try reverse psychology. “Go have fun at the party, kids!” they say, thinking the kids will not want to do anything parents approve of. The kids, knowing the parents are using reverse psychology, decide to use reverse-reverse psychology. “Don’t worry, we’ll stay home!” they say — then sneak out. Hilarity ensues.

Technical analysis is a useful way to gauge market psychology. But when trying to determine the mood of the market, you can easily start over-analyzing and working yourself into a knot. Should you follow the trend or trade against it? But if everyone trades against it, would you be better off following it?

Instead of puzzling over what’s really going on, develop a system that you trust. Do that through backtesting, simulation, and performance analysis. The more confident you feel in how you should react given a market situation, the better your trading will be.

Success may be the result of an upward bias

Under the efficient markets theory, all information is already included in a security’s price. Until new information comes into the market, the prices move in a random pattern, so any security is as likely to do as well as any other.

In some markets, like the stock market, this random path has an upward bias, meaning that as long as the economy is growing, companies should perform well, too; therefore, the movement is more likely to be upward than downward, but the magnitude of the movement is random.

If price movements are random, some people are going to win and some are going to lose, no matter what systems they use to pick securities. If price movements are random with an upward bias, then more people are going to win than lose, no matter what systems they use to pick securities.

Some of those who win are going to tout their systems, even though random chance was really what led to their success.