eli5 how does technical analysis work in trading? and why is it not just astrology?
In: Economics
It’s incredibly too complex to explain like you’re five without a basic understanding of each individual indicator, but technical analysis is just looking at how the stock is currently performing based on the known trading information. There is a bit of psychology associated with trading, you’ll often see patterns that may be helpful in predicting future movement of the stock but it’s like noticing that *70% of the time under these conditions the stock moves in this expected way* similar to how meteorologists try to predict the chance of rain. It will not be right all the time. While a diligent trader can scoop out some big wins at times, almost nobody can beat the market in any meaningful way in the long-term.
The technical analysis done by randoms day trading pretty much is astrology, which is why they (on average) lose their shirts betting against massive investment banks.
There are some great books out there on this, and I’m far from an expert, but as I understand it, it has to deal more with the human factor and how predictable we can be.
For example, with any given stock, people have a general idea of what the average high and low is. Despite all other factors, this helps drive whether they will buy or sell.
So if the average low end is $10, and the average high end is $20, you will see more people buying as it approaches 10 and selling as it approaches 20. This doesn’t change much regardless of the other factors at play etc.
It’s basically just astrology. I recommend reading the classic book “A Random Walk Down Wall Street” by Burton Malkiel.
Maybe to elaborate a bit: the stock market is what’s known as a “second order chaotic system” basically meaning that learning information about the market changes the outcome. So anything you can learn through technical analysis of price movements will quickly be learned by others and subsequently change the projected outcome. There’s a good example in the book “Sapiens” that explains this concept with a simple example. Suppose you have a computer model that can accurately predict the price of oil tomorrow. It predicts the price will go up from $90 to $100 so you buy up barrels of oil at $90. But what if others have developed a similar model that accurately predicts the price of oil tomorrow? Then those traders will also rush in to buy at $90 today. As a result the price will shoot up to $100 today rather than tomorrow. Your prediction about the future price of oil has caused the price to change today rather than tomorrow. The speed of information travels so fast in the modern age that the instant you receive new information that could give you an advantage over other traders, the price of the asset you are trying to speculate on has almost certainly already changed to reflect the new information. This basic fact is what makes day trading nearly impossible to make profitable over the long term. Sure you can have winning streaks, just like you can flip heads 20 times in a row. Randomness can do that sometimes. But once people are on a streak they feel like they have figured out a system and become overconfident until they inevitably lose. And even if there WAS a foolproof system for timing the market, do you think the person who discovered this method would share that information with you? Anytime an advantage is discovered it is inevitable that it will be wiped out almost immediately after other people start to catch on. A system only works if YOU have the advantage and others don’t.
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