The Post-Hoc Chartist

Why do some chartists turn ad hominen when their practice is challenged? The plausible answer is that they are frustrated by continuous failures and are acting under the influence of backfire effect cognitive bias. In essence, there are people who resist change and progress, just like some individuals who still believe in astrology.

After I offered free access to Chapter 5 of my book Fooled by Technical Analysis: The perils of charting, backtesting and data-mining, I received many positive responses but also some attacks and even insults by a few chartists. But this is nothing new to me; when in 2011 someone claimed the Dow was going to 4,000 from about 11,000, meaning a catastrophe, based on just one dubious head and shoulders pattern on a long-term term chart, I responded that these calls are not reliable. I then was insulted by a group of individuals who promote the charting method.

But what does chartist mean? According to Investopedia a chartist is

An individual who uses charts or graphs of a security’s historical prices or levels to forecast its future trends. A chartist essentially looks for well-known patterns such as head-and-shoulders or support and resistance levels in securities so as to trade them more profitably.

I am more generous than Investopedia and have extended the above definition to include technical indicator patterns in addition to classical chart patterns.

Is charting a profitable trading method? Most traders who used this practice and are honest know the answer: No, it’s not profitable. But some teach the principles of charting because it is easy to do that and profit.

Below is an email I received from a market professional (no editing):

Michael,

I read your excellent piece on classical bar charting and could not agree more with your conclusion. Over the course of many years, the value of classical bar charting has greatly dissipated. With markets now trading almost 24 hours, oftentimes in thin market conditions, classic chart patterns have become distorted. Now everyone can be an expert in classic bar charting because of pattern recognition software except for the high frequency guys who do their best to mangle the patterns.

The reason that classic bar charting worked in the early days was that no one used it. An original thinker like Richard Schabacker could find gold in chart patterns because no one understood them or their value. It is amazing that current practitioners of classical bar charting don’t understand the value of their craft has diminished because everyone sees and understands the same patterns. As a result, their impact has become negligible, with some exceptions.

There is a gentleman on the Internet who touts his classic bar charting methods and imparts his pearls of wisdom to those who are willing to pay him several thousand dollars. It is a pity that these clueless souls don’t understand they are learning a craft that has no practical use anymore. This gentleman also makes ridiculous predictions based upon classic chart patterns. One prediction made during the last couple months was that sugar was going to 60 cents when it was trading around 25 cents. He made this prediction based upon something he saw on a multiyear chart. Rather than go to 60 cents as he had predicted, sugar headed south to 19 cents. He also made a claim that corn was going to $3.75 based upon something he saw in a chart. Hopefully, as his fortune-telling continues and is proven wrong, people will get tired of it and realize he’s full hot air.

Keep up your good work on this subject Michael. Hopefully you will spare many new entrants into the investment field the pain of needless losses.

Kind regards,

Garry

Actually, most charts I have seen with a few lines, patterns and indicators are ridiculous attempts to forecast future direction, resistance or support, trend or volatility. Frequent failures of classic chart patterns are the proof. A few examples from recent past are included in my book. I did not make up the examples, most were highly touted patterns in the blogosphere by chartists before they failed. No word after the failure of course.

It may sound counter-intuitive but as I demonstrate in my book, chartists have to trade more frequently than even short-term swing traders to realize the same profits. This exposes them to higher risks and eventually to a higher probability of ruin.

For example, a massive top failure in bonds (TLT) during 2011-2012 surprised a large number of chartists:

Figure 5-5. Massive complex head and shoulders top in TLT. Fooled by Technical Analysis: The perils of charting, backtesting and data-mining – Michael Harris

I write in the book:

The most notable incident of a classic chart pattern failure was that of a complex head and shoulders top formed between November 2011 and March 2012, as shown in Figure 5-5. During that time, chartists had high expectations and the pattern formed in TLT was extensively discussed in the blogosphere. Its failure caused disappointed but also a backfire effect in a large group of chartists, i.e., a tendency to even defend chart patterns more strongly. This and other cognitive biases contribute to another adverse affect from using such trading methods, as it will be discussed below.

Traders must use a concrete method that is free of subjectivity and follow strict signal and risk management rules. Otherwise, ruin is certain. Systematic trading allows obtaining an estimate of trading expectation and performing statistical tests. Such analysis is impossible in the case of charting because it is subjective.

Would you bet in a game of a fair coin toss if I did not tell you the expectation? Doing that would be an incredibly stupid decision. Yet, this is similar to what most chartists do, i.e., they have no idea of the expectation of their method.  Although there are a few academic studies that have attempted to estimate the expectation, their results relied upon some automated method of chart pattern recognition and no additional heuristics and are limited in scope due to this.

Finally, in my book I talk about a class of traders called expert chartists who can profit from classical chart patterns but because they mostly use them for risk management, not for initiating trades. However, even in that case the expectation is not known.

Charting will not go away easily as long as some people believe there is an easy way to make money by looking at charts and are arrogant enough to think that in this way they can outsmart market professionals and algos. History shows that technical analysis has acted as a wealth-redistribution mechanism from those that think this way to market professionals and brokerage industry.

If you have any questions or comments, happy to connect on Twitter: @mikeharrisNY

Subscribe via RSS or Email, or follow us on Twitter.

Charting and backtesting program: Amibroker

Disclaimer

Technical and quantitative analysis of Dow-30 stocks and 30 popular ETFs is included in our Weekly Premium Report. Market signals for longer-term traders are offered by our premium Market Signals service. Mean-reversion signals for short-term SPY traders are provided in our Mean Reversion report.

Copyright Notice

This entry was posted in Technical Analysis and tagged , , . Bookmark the permalink.

Leave a Reply