Technical trading is not as easy to define nowadays as it was in the 1980s when it become popular. It is no longer limited to technical analysis and indicators but encompasses a wide variety of methods. Most of the methods are well-known, some are less known and a few are known only to their inventors. All methods however have something in common: they do not look at intrinsic value of financial assets but only at price and volume. Who are the winners and losers of technical trading?
This is a condensed and edited version of a previous post which made references to specific mathematical aspects of technical trading. In this post, I will concentrate on the winners and losers of technical trading.
Discretionary technical trading
The win rate of decisions based on discretion will approach 50% over time due to the law of large numbers, for the best of traders. Thus, the best of traders are able to win only if they can make more than they lose on the average (“Let your profits run and cut your losses short”). A careful analysis of the markets shows that low risk/reward ratios are hard to realize and maintain. Some will succeed due to either luck or skill but remain a small percentage of the total. Estimated failure rate: 95%
Technical analysts are a specific category of discretionary traders and they rely on a traditional methodology based on the identification of chart patterns, trend lines, retracement levels, indicators and a host of other methods. This style of trading easily leads to compulsive actions triggered mainly by subjectivity and wishful thinking. There are always some who develop an edge using this type of analysis but they have invested the amount of time and effort that is way beyond the norm. In my opinion, 99% of technical analysts fail eventually.
System trading was invented to remove subjectivity, wishful thinking and emotions and thus reduce the failure rate. Supported by some big brokerage houses it was presented as a way of avoiding the inevitable, which is account ruin. However, this approach created more problems than it solved and on a much higher level in terms of complexity. On one hand, it became evident that developing trading systems using computers is not for everyone. Only a small percentage of traders have the knowledge needed for this job. On the other hand, it soon became clear that the performance of system traders was similar on the average to that of discretionary or technical traders. I will not enter into a discussion of the reasons here. Some are listed in the other post. But, in principle, most systems fail because because when they are designed they are fitted to past market conditions. The failure rate is estimate to be around 95%.
Price Action Trading
Price action trading is very hard to model and analyze with a computer. It involves, amongst other things, tape reading, trading price patterns, support & resistance, swing highs/lows, reversion to the mean, pairs trading, etc. These methods can also result in compulsive actions but the trader survival rate is much higher and in my opinion the failure rate is close to 75%.
High frequency trading (HFT)
This style of trading is beyond the reach of retail traders due to its complexity and high upfront cost. It is a proven high expectation generating process and this can be justified mathematically. It has nothing to do with front-running or other misconceptions of the public. The proof is beyond the scope of the post but intuitively, these traders profit from providing needed liquidity to the market. Very low failure rate at this point.
Technical trading has a very high failure rate in general, except in the case of HFT. Price action traders have a better chance than those who use traditional and naive technical analysis. System trading has not worked for the majority of traders because it is plagued by problems at a much higher level of complexity than they can deal with.