What does the chart say?

A new piece of academic literature argues that if you are an individual investor trading options on the basis of technical analysis, you have made some very poor decisions. The researchers studied Dutch discount brokerage clients for the period 2000-2006. The key take-away:

Technical analysis costs investors on average approximately 50 basis points per month in raw returns from poor portfolio selection decisions, and 20 basis points from additional transaction costs. Notably, the impact of technical analysis is concentrated among high derivative rollers, where the costs are much higher: 140 basis points in raw returns, and 29 basis points from additional transaction costs.

That translates to a cost of about 8.5% a year for normal traders, and about 20% a year for high rollers.

We had also linked to studies in the past that looked at specific signals. For example, Adam Grimes ran Fibonacci ratios through the grinder. His conclusion: mathematically it does not make sense for traders to use Fibonacci retracements when trading.

When you put these two studies together, it leaves us with an interesting question: why bother with technical analysis when a) it doesn’t work in the aggregate, and b) one of the most popular charts, Fibonacci ratios, have no statistical basis in fact?

In a recent interview with Josh Brown, technician Greg Harmon had this to say:

Most traders or investors that criticize technical analysis do so because they assume that the result of the analysis is a roadmap, a direction with certainty. It is nothing of the sort. Technical analysis is about the possibility. Technical analysts and traders will draw all sorts of lines and spout off support and resistance levels that appear to be full of certainty. Their analysis is not about identifying points of certainty but rather points of reflection, where price history has shown a price level important and so might make it important again. Might.

In my mind, looking at a chart is a bit like getting a “hall-ticket” pooja done at the Ganesha temple before the exams. You know you have studied hard and done your home-work, but if not-pissing off the Gods costs just Rs.100, you might as well get that done too.


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