The Perils of Technical Trading in Stocks

I was first introduced to technical trading as a software analyst. I was hired to write some proprietary algorithms for a stock and commodities trading group. When I was first introduced to the principles of technical trading, I was blown away. I had thought that fundamentals were the only way to trade (in fundamental trading you look at the companies balance sheet and how well it is doing and whether its markets are expanding and contracting. In technical trading, you just look at the performance of the price alone to gauge what will happen next.)

Here is an example of a very simple algorithm in technical trading. The red line is an exponential weighted moving average of the stock price plotted against the actual price day by day. The rule is when the red line is above the stock price, the price will fall, and when the red line is below the stock price, the price will rise. And it can work rather well. Look at the 5 day example below:

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It works even better on the long run. Here is a one month run. It is all neat and tidy. It looks like any fool can make money, and that this is a huge money spinner. It truly is the Dummies Guide to Getting Rich. So what's the catch?

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The catch is that technical trading doesn't work all the time. Fundamentals can trump technical trading. Emotions of the marketplace can trump technical trading. If there is panic because of a terrorist attack, or if there are bad job creation numbers, stocks fall. That is why I don't trade stocks based on my proprietary systems. But I do like to watch what happens.

Do you know why they call computerized stock traders "day traders"? Because it is too dangerous in technical trading to hold a stock overnight. This is a prime example illustrated below. I am using my favorite whipping boy stock Facebook. All of the above charts are the official stock prices during stock market trading hours. But there is pre-market trading going on. Examine the stock chart below. If you will notice, the blue stock price is above the red line meaning that the stock should go up and up. But the stock is Facebook, and today Facebook will announce their earnings. They aren't expected to be that hot.

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So if you went to bed last night, dreaming of counting your money after Facebook stock rises, you woke up this morning to a nasty surprise. The stock is down over 6% before the market opens. If you were holding a long position overnight, it's not champagne and caviar tonight, but dog food spread thin on crackers.

Technical trading is not for the weak of heart, and as the Gambler says " You got to know when to hold them, when to fold them, when to walk away, and when to run"!