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Conventional Technical Analysis Strategies, A Flawed School of Thought

Tue, Nov 17 2009, 13:19 GMT
by Sam Seiden

Online Trading Academy

Conventional technical analysis strategies have been around a long time. Some say this school of thought dates back more than one hundred years. While it is popular with traders and its rules and beliefs fill entire sections at all major book stores, I would argue that this school of thought really offers little to no edge in the world of market speculation when it comes to strategies. I have written on this topic before and each time, I receive some not so happy e-mails from those who disagree with me, but that's ok. If we all agreed, we would not have markets that move. Everyone would be willing buyers and sellers at the same price.

Before we dive into this topic, I want to review part of an email with you, sent to me from one of our very good Extended Learning Track (XLT) members, Shawn. He wanted to share a swing trade he had made in the stock, Alcoa (AA).

Sent: Fri, Jun 12, 2009 1:34 pm

Subject: Trades I Made Today

Hello Sam,

Today I made two short entry trades and would appreciate your input on these trades. I believe they were both good trades but I would like a second opinion. The first is on AA, it came right into a supply level on the daily chart where I shorted it. My entry price was 12.08. My first target is at 10.85 which is 3:1 and my second is 10.03 which is 5:1.

Thank you for your time and I look forward to the XLT sessions next week.

Thank you,

Shawn W.

As you can see in the upper left corner of this daily chart, Shawn identified a clear supply level. There was a nice pivot high which was followed by a gap down from that pivot high suggesting a huge supply and demand imbalance; much more supply than demand. A while later, moving over to the upper right side of the chart, price eventually rallied back up to that supply level which is where Shawn sold short. He took this trade exactly according to our rules... Selling short to the novice buyer who was buying after a rally in price and at a price level where supply exceeds demand. As price fell, Shawn took profits on his profitable short position at the circled areas on the chart. This means he covered his short position by buying at the circled areas.

Now, let's take off our supply and demand hats and think in terms of conventional technical analysis. If you look at the whole chart, you will see the pattern that is in every conventional technical analysis book ever written. It's one of the most popular chart patterns in history, the Double Top. Let's stick to the conventional rules of the double top and see how the double top pattern/strategy would work for us in this example. First off, according to the books, when can we say we actually have a double top? It's not where Shawn shorted at, it's much lower. Most would agree that according to the technical analysis books, the double top becomes official at near the low of the chart. I will be generous and make it official at the Neckline seen on the chart. The Neckline is what the books tell us to draw and this tells us where to sell short. The rule is to sell short once price breaks below the "neckline." I have pointed an arrow at that level in the illustration below. Now I ask you... Does this strategy that has been around as long as technical analysis itself make ANY sense to you? If you said no, I agree. Why in the world would we want to sell after a decline in price which is the entry point of every double top and in this case, also sell short right into an area of demand (support)? The answer is simple. No consistently profitable trader would do that. Why not sell short where Shawn did which is where supply exceeds demand? That is the low risk, high reward, and high probability time to sell short. Lastly, as our XLT member was buying back his shares in the circled areas on the chart, who do you think was selling to him? It was probably the folks who read the books. This is exactly how trading and investing accounts get transferred daily from those who follow the herd and don't know what they are doing, into the accounts of those who do.

The big flaw in conventional technical analysis strategies are that they ignore how you profit when buying and selling anything. Almost every rule for entering a market has you entering the market well after the move is underway. A successful buyer and seller of anything doesn't take that novice action. As I discussed a couple of weeks ago in my piece, "The Avocado",  you would never be willing to pay the grocery store $4.00 for an avocado when they are selling them for $1.00, no matter how much you like guacamole. Ice cream may be a different story but I think you get the point. The trap is that this flawed school of thought ignores the reality of how markets work and money changes hands.

Just because something has been written about the same way for decades and sells millions of books, does not mean it is correct information. Just because almost every conventional technical analysis book ever written teaches the double top the same way, does not mean it works. As we can see, this conventional pattern makes absolutely no sense. You would never take this foolish action when buying or selling something in any other part of your life outside of trading. Leave this novice action to the residents of Foolsville. What you can do is take this conventional strategy and customize it, wrapping real demand and supply rules around it and now you have a strategy that gives you the edge to enter this trade before the novice double toppers.

If you are unfamiliar with the double top and want to learn more about it and its rules, Google it. I just did and found 110,000,000 links for this obviously popular pattern. After you read the first million, you will see that they all offer the same conventional rules which give traders the same conventional results. Instead of reading all the trading books and learning to buy and sell in markets when everyone else buys and sells (no edge)... Instead of acting on the advice of others who likely get paid from advice, not from trading... Pay attention to what is happening in front of your eyes. Pay attention to what is happening around you. Pay attention to all the simple realities that others (your competition) never see.

To get what you want in life, you must do what you have never done before. This begins with thinking like you have never thought before. This is what leads to results that you have never experienced before. Don't think in conventional terms, think in REALITY based terms and when it comes to money and markets, wrap the time-tested laws of pure supply and demand around every action you take.
Lastly, never forget this ever-important point. You can't be consistently profitable buying and selling where everyone else does; it's not possible. You have to have a strategy that gives you the edge that allows you to enter BEFORE everyone else, at the right time and when the risk is low and reward is high.

Published on  Tue, Nov 17 2009, 13:19 GMT