I found myself surprised to be a fan of technical analysis. I initially figured that the market would at least be weak-form efficient, even if the other forms were hard for me to swallow (just because I’ve taught this stuff doesn’t necessarily mean I *believe* it - the trick is knowing when the ideas are useful and when they aren’t). But over time, I’ve come to believe that TA actually has some value in short and medium term time-frames. I think technicals do capture short and medium-term changes in sentiment, and I think (though don’t have proof) that these ultimately feed back into risk premia. So the idea of “buy when others are fearful; sell when they are greedy” can translate to a TA mindset.
I want to point out that looking for “the best technical indicator” is a lot like searching for “the best valuation metric.” Like valuation, it is very context dependent. Every time you come down to one indicator or valuation metric, you start to realize “it doesn’t really work well in this other context, so you need to use a different one here.”
In the case of TA, the context depends a lot on things like what your transaction costs are, how long you intend to hold positions, can you sit on cash while you wait for an entry, and - above all - your personality. Traders are pretty unanimous in mentioning the psychology part of it - you need to choose an indicator that resonates with your trading/investing personality, because if you don’t, you will second guess the signals it gives you and not have the discipline to follow the signals, cut your losses when they don’t work, take your profits at the appropriate time, and manage your position sizes appropriately. I suspect that TA improves people’s trading not so much because the signals are magic (some are better than others, for sure), but because using them enforces discipline and serves as a crutch against one’s emotions about making and losing money. It sounds really crazy, I know, but even the guys who use astrology may actually improve their trading (vs running with gut feelings) if their astrological analysis comes along with sensible stop-loss and position sizing disciplines.
As for personalities, LPoulin pointed out that most people break down into trend followers (momentum people) or countertrend traders (mean-reversion people); there are also some people who are carry types, but I haven’t fully thought about how well TA mixes with carry approaches. Momentum people tend to go with moving averages, MACD, RSI. Countertrend people tend to go with Stochastics, other similar “oscillators,” or Bollinger Bands for their entry signals.
Things like ATR (average true range) are useful for determining stop-loss thresholds and (depending on your system rules) profit-taking thresholds. You can also use them for determining position sizes, the basic idea being that no position should cost you more than X% of your capital if it goes against you, and you use ATR or other volatility indicators to figure out what size position will adhere to that risk budget. Of course, things can gap against you sometimes, but that’s one reason that X% needs to be pretty conservative, and you try to make up for it by trading uncorrelated assets so they won’t all gap at the same time (as much as you can avoid it).
Elder’s force index always appealed to the physicist in me, but in practice I find that it is a coincident or even lagging indicator - by the time I get a signal, I feel like most of the move is over. It’s useful as a diagnostic tool, but I don’t find a good trading tool.
Most technical analysis is basically three-stage: you have 1) a trend (or other chart pattern), then 2) you have something that signals a possible change in that pattern, and 3) you have second indicator or event that confirms the change in that pattern. Generally, you don’t actually act on a signal until you get to stage 3. If the signal turns out to be a false signal (and you’re back to the trend at stage 1), you cut your loss quickly and wait for another signal.
Ultimately, people tend to choose one or two indicators and run with it: many of these indicators catch more or less the same stuff, and the trade-offs tend to be that some catch moves faster, but with more false positives, while others are more reliable, but give signals somewhat late. If you need more reliability because your personality is that way, then choosing a faster one can work, but you’ll be lax to act on the signals. If you are happy to take a bunch of small losses for an occasional large gain, then you probably want a signal that is less reliable but signals earlier.
It is important not to use too many indicators simultaneoulsy, because you can easily over-optimize things and find a backtest that works beautifully but then performs horribly out of sample (i.e. going forward). This is especially true because some indicators condense many different measurements simultaneously and therefore consume more degrees of freedom than you’d expect with just four or five numbers.
A lot of people think that technical analysis is about seeing a pattern and then trading on the idea that it will complete, but actually it’s the change in patterns that is more important. If a pattern looks like it is going to be a cup or a head and shoulders or something like that, but then stops and turns in to something else, *that* is the signal to go long or short. What the patterns do is warn you to get ready to make a change.
For a valuation guy like Bromion, my guess is you are holding your positions for a long time, and so the real use of TA is to avoid entering long positions while they are still falling and to avoid shorting things when they are still rising. So obviously you may want to have a trend indicator like a moving average to spot the direction, and then mix that with an oscillator to try to detect when something has come off of a bottom. Bottoms can be jumpy though, so it’s important not to obsess about catching the very bottom, which is the hardest point to get, and if you are doing a value strategy with a long holding period, it is nice, but not truly necessary to get the exact bottom.
Don’t forget that TA can also be useful for exit signals once you’ve made an investment. If something that was low valuation has performed well due to some catalyst and is now at high valuation, it can be time to take a profit, and a technical indicator may help with pulling the plug. I think that this is a place that I haven’t heard a lot of value people consider TA… I hear about using TA for entries, but the discipline of when to exit isn’t always so clear, but is ultimately just as important.
It’s taken me a long time to get familiar with TA, so I was hesitant just to dump a bunch of knowledge on someone who comes here saying “hey, just teach me everything you know about something,” but bromion has made some great posts on valuation, value investing, and especially on identifying companies likely to blow up, so one good turn deserves another.