A written response to an article I read a couple weeks ago written by Andreas Clenow, “Why technical analysis is shunned by professionals.”, Following the Trend. Full disclosure this is an essay that is written for school so it will sound more academic than I usually prefer when I am writing a blog post. I was told by a smart man that I should explain everything like sex. You don't need to study sex to understand it. This is not an essay that you can understand like sex so I apologize. Enjoy!
Response: Why technical analysis is shunned by professionals
I have pondered the legitimacy of technical analysis while I’m developing my trading strategy. I think for a majority of this article I would honestly agree with his evaluation on the ‘indicator analysis’ as a snake oil market that relies on the pseudo-intelligent concepts to legitimize their bollocks. It’s selling pans to the gold panners. I want to propose a thought that might help explain why Fibonacci ratios work though. At the end of the day it’s just legitimized and quantifiable superstition, but regardless of your perspective on the underlying fundamental reasons why this should or should not work the outcome is it does and it can be observed repeatedly if done correctly.
When I first started trading I went straight for technical indicators to tell me how I should trade. This is a very common approach to beginners who lack understanding of why the market behaves like it does. I am a big advocate of using absurdist psychology to evaluate market movement. Wouldn’t trading be so easy if we had a mathematical algorithm to make us money? For lack of words, it’s a child's attempt at rationale. The truth is the mother market is solvent. It does not obey a master because it has none, or at least not a mortal one. If there is such mathematical formula that could accurately predict human behavior I would guarantee we would have much bigger problems to worry about. Humans are for the most part irrational and unpredictable except when grouped together by demographic.
There are niche sectors of human nature that can be observed which involve politics and economics which we will be focusing on in this essay. Turns out we have already proven that the market’s bid and ask spread, otherwise known as the tatonnement between two parties, behaves similar to Heisenberg's Uncertainty Principle. If you observe the equilibrium price of a market you cannot accurately determine the momentum of a market. Heisenberg similarly stated that in quantum mechanics you cannot determine the mass of a particle and the momentum of the particle at the same time. Think about a ball being tossed in the air. Just by ‘perceiving’ the ball you can see the ball is in motion, but we cannot accurately predict where the ball will land. Any Algebra 101 class will tell you that using parabolas we can determine where the ball will land, but this is a benefit of having the proper tools. In a macro and micro scale we still lack these tools. It is very hard to quantify social sciences. “We study the relationship between price spread, volatility and trading volume. We find that spread forms as a result of interplay between order liquidity and order impact. When trading volume is small adding more liquidity helps improve price accuracy and reduce spread, but after some point additional liquidity begins to deteriorate price.“ (Sarkissian, pg. 1) This is a fancy way of saying, that if we notice a lot of transactions taking place on a market (volume increase) then we should expect the spreads to decrease and overtime the high liquidity (volume increase) will deteriorate price (change in equilibrium), so once spreads increase we should expect volume to decrease which will slow the market down and reveal the new correct equilibrium price. We can’t see with all the dust in the air so we must wait the traders to do their job and once all the dust is settled we know our new price.
This mathematical equation can accurately be observed in the market which contradicts the concept that markets are purely psychological or random. Does quantum mechanics explain human psychology? I’ll leave that later for another discussion, but the truth is the same. The behaviors of a market can be observed in quantum mechanics, therefore the same techniques we use to track particles should give us similar outcomes in a market. This provides us with a very powerful insight which if done correctly can yield higher profit. “It is the balance between Pi and Phi in the space lattice that enables all of this. Pi is the periodic constant of resonant energy while Phi is the stabilizing constant of damped space – together providing the coherence necessary for energy to propagate and atoms to resonate freely. Indeed, even the process of creating new waves can be expressed equally well using either Pi or Phi.” (Merrick) This paragraph is broken down into connecting how Pi and Phi are correlated. Pi is the fluctuating wave that we are able to see when studying volume. Volume goes up creating a price trend and slows down at the end of the trend. Phi, or the golden ratio 1.618, is the base for the Fibonacci levels that traders use to find possible trend reversal points.
Not all technical analysis is the same. “Anyone can make up anything and call it technical analysis. The field now seem to encompass everything from drawing trend lines to astrology.” (Clenow, paragraph 2) When you lump technical analysis systems together of course it only makes sense that it would seem like hocus pocus. The truth is most technical systems are just algorithms meant to track fundamental, or as we discussed quantum, changes in the market. The technical systems that can’t accurately track perceivable changes are more likely to not hold up when backtested. In conclusion the argument that Clenow has proposed is based on rudimentary analysis of the market and upon further investigating it seems to lack any substantial evidence to reinforce his claims. “The poor reputation of technical analysis is well deserved” seems subjective and highly opinionated. The reputation of any trading system should solely be judged on its consistency, efficacy, and the profit it yields. It’s only well deserved if the system does not work.
Sarkissian, Jack. “Spread, volatility, and volume relationship in financial markets and market maker’s profit optimization.”.
Merrick, Richard. “INTERFERENCE.” Phi in Quantum Mechanics | On the Golden Ratio, 27 Feb. 2012, 15:07.