Over my 25+ years as a trader, my view of technical analysis has undergone a substantial evolution. Part of that is due to changes in the market and part of it is due to what I have observed in my quest to produce superior returns.

At first glance technical analysis is a set of rules that are supposed to help predict how traders will act in the future. They will sell a head-and-shoulders top, buy a breakout from a base or dump stocks when a key support level falls. Those rule work quite well at times and some of the basic principles have never really changed.

However, many market players have unjustified confidence in the predictive value of many chart patterns. The statistical correlation for many patterns is fairly week. Head-and-shoulder patterns, for example, tend to produce random results at best which is due in part to difficulty in defining the pattern as well. When technical patterns do work well there are often other factors present like overall market conditions or sector rotation that have a significant impact

Even if you question the predictive value of technical analysis, there is still great benefit of rigid application of its rules. Technical analysis provides an excellent form of discipline. The rules of technical analysis are a framework for a methodology that will help you limit losses and maximize gain.

It isn't the rules themselves that are important but the fact that there are rules. You could create a set of very random parameters and still have it work very well. For example, use the 22-day moving average as a stop level or sell anything that is extended more than 17% over a breakout point.

Rules like that will work, not because of the rules, but because it forces you to act. Simply taking action is the most important thing you can do when managing positions. The use of technical analysis in some form is a necessity if you want to navigate the market effectively.

However, my confidence in technical analysis as a predictive tool has eroded steadily over the years. It still is very helpful in finding good chart setups, but it isn't nearly as good at predicting what will happen in the future.

Since the basic rules of technical analysis -- TA for short -- are so well know they are one of the primary tools of how computer algorithmic programming. Any programmer can design a system with all the essential patterns that we know. They can even figure out many variations. The rule book is simple, and the computers could easily out-trade any human trying to apply the same set of rules.

When everyone knows a pattern then the next move for someone trying to gain an edge is to use contrary thinking. For example, if the 50-day simple moving average is an obvious stop level then the best way to buy the stock would be to wait for the stops to trigger at that level and cause a spike lower. If your positive view of the stock is correct you will be rewarded with an attractive entry point.

We have seen a good example of this phenomenon in recent years as V-shaped bounces have become the norm. Anyone with a smattering of knowledge about TA know that when there is a break down there is supposed to be a retest of the lows before the market returns to health.

The major bottom in 2009 never saw a retest and we have had very few retests since then. The reason is that the computer algorithms have benefited from buying before the crowd of slow moving humans can adjust their emotions and jump back in to the market.

It doesn't stop there. Once you start thinking in contrary terms you naturally want to go even deeper. That is what many of the algorithms do and it is way so often we end up with action that seems illogical. TA has become a device more for manipulation than for logical predictions.

Anyone that thinks they can predict how much further the S&P500 will bounce off the recent lows is delusion. We have already seen violations of all the standard rules about support and resistance

TA is still highly useful to navigating the market, but you cannot approach it as a simplistic set of rules. You must think beyond that if you want to use it. Quite often it is still a self-fulfilling prophecy. Breakouts work because so many people are willing to believe that they do work. The same goes for V-shaped moves in the current market.

To effectively use TA as a predictive tool these days you must think beyond the rule book. How will the machines use certain patterns to gain an edge? How will news headlines serve as triggering events like the unwinding of the short volatility trade.

Charts have always been about emotions and psychology but now there are always tools of manipulation. Understanding the interrelationship is an art not a science.

At the time of publication, Rev Shark had no positions in any stocks mentioned.

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