Transcription
What's up guys? It's Coding Jesus, and in today's video, I want to talk about why I know, not I think, not I believe, why I know that technical analysis is a load of garbage.
For those of you that are new to this channel, I am a high-frequency trading software engineer. I write algorithms to trade automatically, or algorithmically rather, with the exchange. And I also write trading applications to fill out traders, to submit custom strategies, to view their risk, to trade manually with the exchange. And that also involves creating charting software. So I am by no means new to charts.
Okay guys, what is technical analysis? If you can even call it a form of analysis, why do people believe in it, and why is it totally garbage? Technical analysis is a belief that future price movements can be predicted by current and previous price movements. Of course, the chartists will tell you that there's also a MACD and volume and other indicators. It's not only price, but at the end of the day, guys, it comes to price.
Okay, why do people believe that technical analysis works? The first reason is that they believe that prices are not random. The only way that you can conjecture that prices follow a trend is if you believe that prices are not random. Prices are indeed random, guys, and I'll get to that in a sec. But what that really means is that prices cannot, or future prices rather, cannot be predicted.
The second reason why people believe that technical analysis works is because it's simple. It plays to our lizard brains. It plays to our inclination to do the least amount of work and gain the most benefit from doing so. So what a trading guru will tell you is, "Hey man, just buy my course. You know, all you have to do to get that yacht that you want, to create generational wealth for you and your family, it's to just look at a price on a screen." And that's all you need to know. It's that simple. You can make millions of dollars. It's just that simple. It plays that lizard brain characteristic that we have as all human beings do: the least amount of work, gain the least amount of benefit, have the least amount of stress in my life, and gain the most happiness. But what chartists will end up seeing themselves as is having the most amount of stress and the least amount of happiness. And I think it tells you a lot about an average chartist in terms of their information processing capabilities, that all they do is focus on one indicator. They don't go out and research about the fundamentals of the business. They don't go and understand the market dynamics. All they care about is one indicator. Maybe they can't process a lot of information. Maybe they're too dumb to. Maybe they're incompetent. That's not for me to decide. That's up for you to decide. But just remember, it's all about one simple indicator.
All right guys, the third point is that technical analysis is so appealing because it involves pattern recognition. We as human beings are hardwired by nature, by God, by whatever, to recognize patterns. It is part of our evolutionary biology. We recognize patterns in terms of danger we might feel or that that might come to us if we're in some sort of jungle situation or if we're hunting boar. And those nascent traits remain with us till today. They're, they're probably actually stronger today than they were 10,000 years ago because we nowadays still need to recognize patterns, whether that pattern is in the workplace or in a social setting. We need to recognize patterns, and we are pattern-recognizing machines. Now, what people are sold is the idea that as long as you can recognize a pattern, as long as you can look at a piece of paper with eight patterns on it and say that one of the patterns in this sticker graph corresponds to one of these patterns, then you can make a lot of money. And that appeals to a lot of people.
Okay guys, so why is this fundamentally untrue? The first reason is that prices are indeed random, which means that prices cannot be predicted. Prices are indeed random in the short and medium term. Read the book "A Random Walk Down Wall Street." There's something called Brownian motion. It is a stochastic process, which means in the short and medium term, prices are entirely random. You won't find any trend in the one-second chart. You won't find any trend in the five-minute chart. You will not find any trend in the daily chart. You will not find any trend in the two-week chart. The only trend that people have, or not people in general, retail investors have consistently made money off, is the long-term trend. And the long-term trend is not tradable. Therefore, it does not appeal to day traders because they are focused on changes that happen within the day, where maybe there's a two-day maximum within a week. They are not focused on changes that happen over a year. And the retail investors that make money on the stock market primarily buy and hold. They are there for the long-term trend, not the day, not the minute, not the hourly, not the two-week trend.
The second reason, guys, plays on that simplicity point that I told that I mentioned as to why people are drawn to technical analysis. People that trade technical analysis only focus on price, or rather primarily focus on price. They believe that previous prices can predict current and future prices. They have it entirely backwards because they do not understand how price works or what even is a price. The fundamental underpinning of technical analysis, they do not understand. They do not understand what a price is. A price is a subjective valuation of a given commodity based off their ex, based off the expectations of that commodity's future cash flow. The current price is an estimation based off future cash flow, and the future price cannot be predicted based off previous prices. The price I'm paying today for a given asset is the sum of the discounted cash flows that that asset will generate for me in the future. The price I'm willing to pay for a house is the discounted rent that it will yield for me in the future if I buy it today. It's all about discounting the future till today. But what technical analysts or chartists want to tell you is that they can inverse that. They have it all backwards. They infer that the past can predict the future. That's not what price is. Price is a signal of future expectations for a given commodity, how much that commodity will make you in the in the future. And that's why people like Warren Buffett look at discounted cash flows for a given commodity today to price it, to understand what its future price might be, given what the future will yield for this business.
The third point, guys, relates once again to the, uh, to the pattern recognition part. Human beings, like I said, are pattern-recognizing machines. Now, why is technical analysis bunk? Because you can give the same charts to two different people, and they will see different patterns in that chart. And most patterns will yield radically different conclusions as to the direction of that price. So one person will tell you, "Okay, I see a cup and handle. Whatever. It's, it's bearish or it's bullish." Another person will say, "Oh, I see a head and shoulders. It's, so it's bearish." How can you reconcile the two positions? You can't. That's because human beings will read into the chart whichever pattern they want to see. They will read into the chart what they want to see, and that's how they will make their decisions. You can take the same chart, flip it 180, and the person looking at that chart will come to the same conclusion as they did if that chart wasn't flipped, the same exact conclusion. So human beings will read into the chart whatever they want to read into it. And furthermore, if everybody's reading the same pattern, then everybody should theoretically be making money. But that's not the case. Even if it was true that everybody's reading the same pattern, the mere fact that everybody's reading into it will mean that profits in the space will gradually dry up. Because people will see that signal, and some people act before other people, and so some people will be crowded out of that opportunity.
Okay guys, the fourth point is that people think that technical analysis is legitimate because brokerage firms will issue tech reports on technical analysis. Guys, brokerage firms couldn't give two shits about you. The fact that brokerage firms issued a technical analysis report doesn't vindicate you. It doesn't mean that technical analysis works. Me working inside a proprietary trading firm, I know the psyche of exchanges, the psyche of institutions that want you to trade on their platform. They want the most liquidity and the tightest bid and offer spreads, and they want to generate the most volume so they can get as many fees out of you as possible. So if that means that pretending technical analysis works, sure, why not? They'll feed you as long as you eat it up, if they're going to make money off it. And of course, it's not illegal. So the mere fact that brokerage firms issue technical analysis reports is by no means a vindication that technical analysis actually works.
And the last point, guys, is cold hard facts. There are plenty of empirical studies. One is, I believe, called "Noise Trading and Illusionary Correlation in the U.S. Equities Market." And what that report pretty much has, an empirical study, is that the head and shoulders pattern, that's what they were analyzing in particular, does not yield any profitable trading signals in the long run. It is not predictive of future price movements. All that's predictive of is volume. And what that tells me is that a lot of chartists see a head and shoulders and start taking positions, whether it's bullish or bearish or whatnot. They start taking positions. So if you don't want to listen to anything I said, the empirical data is there to show that what I'm saying is true. And if you want to doubt the empirical evidence, that's another question for another video. I mean, you can go ahead and do that. But most likely, chartists aren't going to read that empirical information because they're only focused on one piece of information, and that is price.
Okay guys, thanks for watching this video. If you liked it, give it a thumbs up. If you hated it, double tap thumbs down to show me just how much you hated it. And subscribe to this channel for more videos, the latest and greatest in Coding Jesus, so you can hear my gospel first. Thanks for watching guys. Cheers.