V.14:9 (387-391): Avoiding False Signals by Joe Luisi

Some people may think that technical analysis doesn't work anymore, but here's one author's solutions to today's challenging modern markets. by Joe Luisi

Having been involved with technical trading for several years, I've noticed that technical analysis doesn't seem to hold the same promise it once did. Indicators and patterns that were once tried and true are no longer reliable; false signals and breakouts occur more frequently. Frequent stop running causes moves that seem to make no sense. Over the years, with computers having become so inexpensive, and data, either real time or delayed, relatively cheap and accessible, many more traders have become technical. Software packages that once cost $400-$2,000 are now available for less than $200, some as low as $20. Look at the classified advertisements of a trading publication, and you can see literally dozens of technical (mechanical) trading systems for sale, with fantastic claims attached. Moreover, everyone seems to have a system for sale. Five to 10 years ago, those same classified ads had only a few systems for sale. This onslaught of technology has created a change in the markets, and if you can't see it or prepare for it, you will become a financial victim.

THE NEW WAVE

Every new technician reads the basics of chart patterns and indicators and applies them to his or her trading, only to find they don't work. So how can traders overcome this new wave?

On the surface, these problems appear to make perfect sense; after all, the more people following the same indicators and patterns, the greater the possibility for aberration. If everyone is following the stochastic indicator and it falls below 30, a classic buy signal is triggered. At that point, thousands of screen-based technical traders who follow this indicator will call their brokers to buy at the market. This rush to the phones causes a brief runup in prices, and so it appears that the signal is working out.

However - of course, there's a however - once the buying dries up, and it always does, no buyers are left to propel the market higher and the only thing left to do is sell. The brief influx was caused by technicians all jumping in at once. This causes a false move up, because the buy side is heavily favored temporarily. After the last technician buys, there are no more buyers left in the market at that price, and therefore, sellers take over and the market reverses direction. The technician scrambles to cover his or her position or lock in a profit, thus adding fuel to the selloff. Hence, the classic false signal.

Let's look at several examples of how the market can make moves that appear to make no sense at all, and then we will look at ways to avoid these situations. Finally, we will look at several patterns that I have found to work over time.