In this episode of Truth About FX, Walter digs into the psychology of technical analysis and would it work for a naked trader. He highlights the importance of understanding your own system and biases and building your strategy around that. He also shares an interesting book by an Australian trader about parabolic up-trends and how can this help you work on your strategy.
Download (Duration: 06:25 / 15.4 MB)
In This Episode:
00:56 – what’s the underlying reason?
01:57 – innate in humans
03:02 – a different President
04:15 – an abstract thought
05:21 – a concrete example
Announcer: Sometimes, forex trading is a wild and wooly place to be. That’s why Hugh is here, to post your questions to Walter, the naked forex guy. Hugh’s got questions and Walter’s got the answers. Here at the Truth About FX Podcast.
Hugh: Hi, Walter. Why does technical analysis / price action / naked trading work and will it ever stop working?
Walter: It’s a good question. I’ve heard this before. First of all, I think you have to choose the right technical analysis. You might love Bollinger Bands and I just think that’s crazy so I just have to go with what I believe which is mostly support and resistance, reliable patterns, that’s the kind of thing that I like.
If it doesn’t make sense to you, you can’t trade it obviously. We’ve talked about that a lot but I think really what this question gets at is, what’s the underlying reason for why these things keeps happening. I think you have to step back and say, “What have I constructed here?”
For example, if you’ve constructed a strategy, a system and by the way this did exist. There used to be strategies that would take whatever the news release was from the non-farm payroll report and they would actually trade the entire month based on that news report.
It was good for the USD, the strategy, the system would be is just buy the USD for the next 30 days. Those kind of things existed. Now the question is, what are you doing here? What is the system doing?
The system is taking advantage of the most important news release at the time. No longer is but it used to be. It’s taking advantage of that and it’s kind of setting the tone for the month. I think that’s the key thing here.
If so, the way I look at it is sort of broad simple terms. I know it’s not simple but just for the discussion here. Is your strategy getting at something that’s kind of innate in humans? Is it like a psychological thing that it’s tapping into or are you kind of gaming the system and just taking advantage of like a flavor of the month, so to speak.
This speaks to curve fitting and over-fitting systems in adding variables, in degrees of freedom and all of that sort of stuff that you get into, specially if you’re on automated trading. You’ll learn all of those stuff but I think that’s kind of the main concern I think, with this idea. Are you taking advantage of something that is like a fleeting thing in the market?
Over the next 6 months every time Donald Trump tweets the USD goes down or whatever or tweets about China, you can do that. I’m sure you can build a system something like every time Donald Trump tweets with the word China in his tweet, you buy/sell USD or something. You probably could, right?
The question is is that really going to work over the long haul? I don’t think it is. I think it’s kind if a curve-fitting thing where obviously a couple of years from now, whenever it is, we’ll have a different President, that’s obviously not going to work because he’s not the President so who cares what he tweets.
So this kind of stuff is what you have to look at and what I like to think and I could be wrong but what I like to think, I think that the data if you look at this kind of, bares this out. The simpler the strategy, the fewer the moving parts, the fewer the restrictions and like when you have your strength system, you turn it into a checklist, the fewer things on that checklist, the more likely it is that you’re tapping into something that’s kind of universal.
That is the great thing about the market. Even when we have humans programming automated strategies, the humans are the ones that came up with the strategy. They’re moving a little bit away from that now but we are actually having programs create strategies.
So that’s kind of like the whole machine learning and all that. That’s a different thing but I think at this stage, where we are right now with trading is that the humans are making the decisions even if they code those decisions into an automated systems. So, if you really have a very simple strategy then you could be taking advantage of that.
Here is an example of what I’m talking about. I know this is kind of… A lot of abstract thought here but a concrete example of this is will be when you look at the charts, and you’re drawing a trendline. Let’s say, you’re looking at an uptrend, you draw a trendline under that uptrend. Do you have to keep drawing more and more, steeper and steeper trendlines to capture that uptrend because it keeps going up in a parabolic move?
If that’s the case, then it’s probably going to fall down rather quickly and that parabolic trend is going to fall off. This is something that I’ve learned from Daryl Guppy. You can read some of Daryl Guppy’s book. I think he’s an Australian trader who lives now in Singapore if I’m correct.
He basically talked about these parabolic uptrends and I thought, “Wow, this is interesting” and I tested it and he was right. Now I think, this is one of those things where we see these across the board. We see these in any kind of market. You can look at bitcoin. You can look at the Euro back in 2004. You can look at all these different things when the market gets really really strong and goes really really hard in one direction, it just makes it and you could just see that technically.
You can turn that into a technical chart where you draw all these multiple trendlines, it’s going to collapse and it’s going to come down really hard on the other direction. That’s a concrete example of what is a technical analysis has tapped into. It could just tapped into basic fear and greed stuff that we deal with in the market.
If you’re able to do that, it’s more likely to last longer but if you’re doing something where it’s more kind of a really focused strategy and/or has a lot of things involved, a lot of pieces on the checklist, so to speak, then you’re more likely to overfit and it might work really really well for a given time and then it just breaks down and stop working. I know it’s a long-winded answer but I think the answer is basically it depends.
Hugh: That’s a great answer. Thanks, Walter.