Trading / Investing based on Technical Analysis: Introduction
"I don't know where to start". said Alice
"Start at the beginning. Go on to the end, then stop," said the Red Queen.
So let's start by stating the obvious:
The objective of the technical trader is "To accumulate capital by maximising profits gained from favourable market moves while minimising losses suffered on unfavourable moves and transaction costs".
In other words, profits must more than equal the sum of losses plus costs.
The above may seem blindingly obvious, but it is at this simplest-possible level that most participants in the game fail, because they expend too great a proportion of their efforts on attempting to perfect forecasting techniques with a view to maximising the probability of profit, and pay insufficient attention to the strategies required to minimise losses.
The first point to note is that the analytical technique(s) used by the trader must "Give him an edge" on the market, in other words produce better than random results: "Monte-Carlo" systems, where stakes are doubled on even bets until a win is gained require enormous initial capital to avoid the risk of ruin. Suppose you bet $1000 on the toss of a coin, doubling the bet each time you lose, and reverting to $1000 when a win in gained. How much will you have won after 2500 throws, and what will your maximum bet have been ? This can be easily simulated using any spreadsheet program with a random function. I ran this simulation 25 times while writing this. Profits varied between $1,164,000 and 1,293,000, On two occasions consecutive runs of 15 occurred. Bets of $16,384,000 would then have been required to keep the sequence going (with no guarantee of success on the next try). No amount of mathematical tinkering can change the basic brutality of these numbers: You gotta have an edge.
A note on transaction costs: The shorter the time-frame traded, the more important aggressive control of transaction costs becomes. An intra-day trader may be capturing 50-point moves, while a position-trader who holds positions for days / weeks might be looking for 500 points. a few extra points of slippage (bid/offer spread) or dollars of commission may not matter too much to the latter, but intra-day trading performance can be seriously hurt by inefficient order execution and excessive commissions. Additionally, the intra-day trader must have on-line non-delayed quotes and charts (which cost money) whereas the position-trader can update charts manually. Basically, all technical traders should use discount brokers, negotiate commissions aggressively (on the basis of trading volume), and challenge execution prices which are out-of-line.
In developing a "reliable edge", two ratios need to be optimised:
These two ratios tend to be negatively correlated: for example, the trader who consistently aims to take 100-point profits while cutting losses as soon as they reach 10 points will obviously tend to be "stopped-out" frequently (causing a low profit to loss frequency ratio) but his average profit to average loss ratio will be high. Conversely, the trader who maximises P/L frequency by placing 200 point stops and 100 point targets will suffer fewer losses each of which will hurt more. Either or both of them may make or lose money over time depending on the quality of their underlying analysis and the consistency and discipline with which they apply their respective strategies.
As a general "Rule of Thumb" : The trader should aim for three profits for every two losses, and a 3 to 1 average profit to average loss ratio. These targets leave room for considerable under-performance before the trading becomes unprofitable overall. (anyone who can achieve both objectives consistently will become very rich indeed).
Note that a free program down-load to model trading results resulting from random sequences of profits / losses with defined probabilities will be posted to this site in June 1998.
Before considering how to determine the size of positions to be taken, let's take a look at the basics of the technical analysis of market action necessary to determine whether to buy, sell or stand aside; and when to take action.