Financial traders tend to either love or hate technical analysis in predicting the behaviour of stocks. And what about fundamental analysis, which some traders swear by? Which school of thought has the most success? And do you have to use just one system or the other to get a coherent trading method that works for you?
Recent research has shown that, as far as can be established, nearly 60 per cent of technical analysis based trading decisions turn out to be profitable. That’s enough, given sensible money management, to ensure a long-term profit. But unfortunately it doesn’t mean that the same percentage of traders using technical analysis to make decisions will be successful.
If you use technical analysis, how can you put the odds more in your favour and reduce the number of losing trades you make? I believe there is a way of doing this, but it does mean acknowledging some of the limitations of technical analysis, and utilising some aspects of other stock market trading systems, in particular fundamental analysis, to get the best possible combination of systems.
Technical analysis assumes the market knows everything and responds to events in a logical manner. In fairness, it has to make this assumption because there’s no way of measuring the illogicalities, fear, greed, mistakes and other psychological factors that influence human behavior in the stock market. It is at its best when used in extreme circumstances, where, for example, a stock has risen sharply and broken through its previous resistance level. And it favours short term trading rather than long term investing.
It’s rather like driving a car while having only the rear view mirror to help you decide which way to steer. It can tell you when you’ve been driving on the wrong side of the road or nearly in the ditch, and if there’s been a pattern in the direction of the car to left and right. But more than anything it can tell you what not to do next, even if it can’t tell you precisely what you should do.
You can therefore use it as a filter, so you’re aware of when you shouldn’t trade at all in any given stock. It’s not easy to apply this because it requires strict discipline, but if you can manage it you’ll save yourself a lot of losing trades.
When your selected stock passes the technical analysis “double negative” test (i.e. it’s not a stock that shouldn’t be traded right now) and you have what you might call a “gut feeling” about it, then you can apply fundamental analysis to confirm to yourself that the next major price move really will be in the desired direction. Of course this will sometimes not be the case – always be ready to cancel your planned trade at the last minute. I believe this system, as adapted for your individual trading style, can help you avoid losing trades and increase your profits over the long term.
Philip Gegan
