An Example Of How Technical Analysis Has Misled Traders

Technical analysis has been a major cause of trader failures along with account undercapitalization. Here we show briefly how untested technical analysis claims about overbought/overbought conditions have misled traders into unprofitable trading.

I expand here on a recent article I wrote about The Failed “Market Is Technically Overbought” Narrative. I do not expect this and other articles I have written to put an end to the massive misinformation with traders as a target. I do not expect any author of a classical technical analysis book to publicly acknowledge the failure since these random rules and methods still have many supporters, usually old timers who try to recoup their losses by teaching new traders that which caused them to fail in the first place.

I have talked about random chart patterns, such as the head and shoulders, in other articles and in my book Fooled By Technical Analysis. In this article I expand on the failed overbought/overbought narrative. I show that what is even more surprising is the fact that during the time this narrative was at play, there was already plenty of evidence to suggest that it was false. Yet, not only they did not stop, but this false narrative is still being widely heard.

The fact that false narratives that were easy to check were persistently promoted makes me very suspicious about the purpose of classical technical analysis but I will hesitate at this point to call it a scam. However, my analysis makes me skeptical especially when considering who the major beneficiaries of traders’ failures were.

For the purpose of illustrating a point only we will consider the strategy of buying when the RSI(14) is in overbought territory and shorting when it is in oversold territory, i.e., doing exactly the opposite of what was suggested in technical analysis texts. This is a long-short strategy. Not that this is not a trading strategy to use but just a way of analyzing market dynamics in relation to some indicator.

Below is the performance of this strategy in S&P 500 from 01/1960 to 12/1999.

The strategy is profitable and this is maybe surprising. What is important is that:

For a long time and while overbought conditions were promoted for selling and oversold for buying, doing the opposite was a profitable strategy. 

The positive performance of the strategy is present in NDX and RUT from inception to 12/1999. Click on images to enlarge.

In fact, in RUT, the strategy outperformed buy and hold in the same period by a substantial margin of about 370 basis points. More importantly, risk-adjusted performance as measured by MAR is also better.

Below is the result of following the predominant paradigm of buying oversold and shorting overbought in S&P 500 during the same period:

There are at least two explanations for the above surprising results:

  1. The failure of the narrative was due to structural factors (high autocorrelation)
  2. Market makers faded the patterns making them unprofitable

We may never know the real cause and probably that is irrelevant. The fact is that traders were told one thing and the opposite happened. Obviously in the zero-sum game of trading some benefited from this.

I will continue with a few more articles about this failed overbought/oversold narrative because in my opinion it illustrates the level of misinformation in technical analysis and how that has impacted traders.

If you have any questions, you can email us at: premium@priceactionlab.com

Disclaimer:  No part of the analysis in this blog constitutes a trade recommendation. The past performance of any trading system or methodology is not necessarily indicative of future results. Read the full disclaimer here.

Charting program: Amibroker

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