Friday, December 18, 2009

Thinking About Technical Indicators

I use technical indicators as a starting point for every trade. They're a valuable tool.

These days I'm using an indicator called Person's Proprietary Signal. It's propietrary; I have no idea how it's calculated. 
But I've also used Bollinger Bands combined with the Money Flow Index or the Relative Strength Index, and I've used those indexes without the bands. I've used Moving Average Crossovers. I've used the MACD and the Stochastic indicators, both separately and in tandem, and with moving averages. You name it; I've used it.

There are a couple things I've learned about technical indicators.

One is that they don't always work. Sometimes, they'll give a bull signal (prices are going up) the day before prices go down. Or a bear signal (prices are going down) the day before prices go up. 

At other times, a bull signal will mark the start of a price increase of epic proportions. A bear signal will begin a price collapse that leaves a company's stock in smoking ruins. 

And there is no way for me, the trader, to determine at the time of the signal whether its a good one or a bad one. 

The other is that signals are prone to whipsaws. A whipsaw is when you get a bull signal one day, a bear signal two days later, and then another bull signal the day after that. And for all the drama, the price really doesn't do much. 

People who say there are bulls and bear in the markets overlook a third important group: confused puppies, who don't know whether they're going up or down, or just staggering across the living room carpet. Technical indicators don't deal with confused puppies very well.

Also, all technical indicators have this in common: They take the past and aggregate it in some way in order to produce a signal. A technical indicator is a simplifier. It attempts to somehow smooth the frenetic ups and downs of the trading day, as prices change by the second, and from that simplification to extrapolate future behavior of prices.

On the face of it, that's a fairly extraordinary thing: How does simplifying the past help me understand the future? Rather, it seems more sensible to think that embracing the past in all of its complexity will make the future clear.

Physicists, after all, have gained greater understanding of the universe by dealing with smaller and smaller chunks of energy and matter. Doctors cure disease by understanding the chemistry within each cell, and biologists understand human behavior by focusing on the microscopic firings of nerves in the brain.

In some ways, technicals indicators seem to be artists masquerading as scientists. They say, "We're precise", but in practice, they're not.

For me, they have a somewhat musty 19th century feel to them. When I use them, I  feel as though I'm time traveling, back to the days of Sherlock Holmes, that great extrapolator from limited facts, with his pipe and magnifying glass intoning, "Elementary, my dear Watson".

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