Why Technical Indicators Fail

May 1, 2013

Years ago, when I spent a lot of time traveling and instructing people how to trade, I took a great deal of time explaining the benefits of using a moving average, and other tehcnical indicators such as a MACD, stochasitc, and others. 


In recent years, I find it hard to promote most of those technical indicators as valid trading tools. That's because I have since spent countless hours back testing the most widely used indicators, seeking to find some validation to price prediction, but disappointingly finding very little prediction value in any of them.


Anyone who has spent much time in that same back-testing process has also probably learned, the odds of an indicator predicting future stock price or stock market direction. turns out to be not much better than a coin flip over time. 


This is partly because price is an historic event,  and any technical indicator naturally "lags"  current data as it attempts to show in a slightly different way, what has already "happened". The hope of course, is that the recent past might have the possibility of continuing.


Indicators however, actually become deceptive to the naked eye when estimating their effectiveness. A true back test though, that objectively measures  their results, won't lie.


To those who have been relying on such technical indicators, back testing can be an important eye opening experience. Hard numbers quickly show that nearly all technical indicators can succeed, but then fail, with equal odds.  That's called random possibility.


The reasons for their lack of success is that most indicators are built on a single set of data - the price.


A MACD for example, is a measurement of divergence of price using two moving averages. A Stochastic, uses the averages of previous highs and lows of the price.  Moving averages, momentum, RSI and other indicators are also based on price for their output as well.


Unfortunately, for the investor depending on such indicators, even trying to use them in combination won't add much to a less random outcome. That's because even when combined, it is like taking a two dimensional picture and flipping it around to observe it from its sides or back.  But a flat picture does little in helping provide a clear perspective of a multi-dimensional object. You just end up with different views of the same two dimensions.


If you are going to succeed in trading, the reality of the limitations described can be discouraging, if not outright dangerous to a trader's account.


But there is some hope.


Understanding that every indicator lags the current price is an important fist consideration. Lessening that lag mathematically can be helpful, but you will still be analyzing history, and then "inferring"  future behavior.  At face value, that approach is still guesswork.


Adding other factors that don't rely on price could prove helpful.  Volume, market breadth data (i.e., new highs/lows, numbers of stocks above/below their 50 day moving average), volatility etc., will add some new "dimension" to price based only indicators.


All considered, after 25 years of stock market research, what I have found to be the best predictor of future direction, is the factor we call  "time". Interestingly, time is usually a secondary factor in technical analysis, used to "tune" a moving average or other indicator, but not a primary identifying trading indicator by itself.


To measure time vs. (price, volatility, volume etc.) we use something called "spectral analysis" (seeMarket Cycles  and Advanced Topics).


That advanced mathematical approach is designed to find periodic activity which has some consistency in the data. An important discovery within market data has been that much of a stock or market's ultimate price action,  has and continues to show a significant correlation to time. In other words, ithe timing of a stock or market's undulating rise and fall,  proves to be quite PREDICTABLE.


With that periodic motion identified (the time between lows for example), a trader can then use that information to "plan" when it's going to be time to go long, and the likely time to go short. Used in combination with other trend indicators, and non-priced technical tools, the ability to increase trading precision can be dramatically improved.


Here at The Market Forecast, that's exactly how we approach trading the markets.


We look for cyclical analysis indicating an "UPCOMING" change in direction, and use other technical indictor's to confirm a newly developing trend. It dramatically increases our chances for success with each trade. The end result is a substantial improvement in trader confidence, but more importantly, the opportunity for much bigger bottom line profits.


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