Technical Analysis - Distinguishing Between Noise and Useful Chart Patterns

Technical analysis has been around since the 18th century and over the past few decades more and more individuals have been turning to this form of analysis partly due to the continued advances in computer and internet technology, but also due to the increased literature on the subject. Although an ever increasing number of traders are attempting to fulfill their dreams of riches earned on the market through day-trading using technical analysis techniques, the reality is very, very few of these traders ever become successful. Consistently earning money on the market (i.e. not from a stroke of luck) is extremely difficult, and unfortunately the majority of introductory literature on technical analysis portray it in a manner that makes one believe that all it takes to earn money with technical analysis is the ability to detect certain chart patterns. However, this is a massive oversimplification as instead it is extremely difficult to master technical analysis in a manner which allows for consistent long-term profitability, and is certainly not as simple as just entering trades each time a certain chart pattern forms. The majority of books on technical analysis are full of explanations and pictures of chart patterns such as rectangles, pennants, head and shoulders, and saucers to name a few, which the author will suggest that when formed offer an excellent time to enter as these patterns consistently precede significant moves in price. New day-traders look at the examples provided in books as well as online tutorials and are led to believe that once they gain the ability to detect these patterns in a timely manner they will then see the dollars roll in. However, not surprisingly a technical trader with this mindset will soon discover that it is not nearly as easy as most of the literature on the subject makes it out to be. Instead after the formation of these supposedly all powerful patterns, price is just as likely to go sideways or in the opposite direction then what is taught, as it is to move in the expected direction. Now this is not to say that technical chart patterns are worthless, as in fact they can be very valuable, but in order to make use of the great power one can obtain from technical analysis a trader must learn how to discern true signals from the noise in price movement. (Just to note before continuing, when I use the term noise, I am referring to movement in price with which technical analysis does not have the ability, at least in its current state, to interpret in any useful manner.)

Examination of a large sample of chart patterns inevitably reveals that while in some cases entering after their formation does indeed provide excellent profit potential, unfortunately at least as often the patterns lead to either movement in price in the opposite direction then what is to be expected, or prolonged sideways movement. It is in the ability of the day-trader to be able to distinguish between the patterns which have a high probability of leading to a significant up or down move and those which are just noise that determines whether a trader will be successful. While there are many ways that a trader can do this and most successful day-traders will in fact develop their own unique methods, there are two simple and obvious ways a trader can begin to improve this ability; firstly, a trader should be aware of the underlying longer-term momentum of the market which they are trading, as this can really help a trader filter out some of the patterns which are unlikely to produce winning trades. Secondly it is extremely beneficial for traders (especially day-traders) to know when any significant news announcements are going to be released (earnings reports, GDP numbers, employment numbers, Federal Reserve rate announcements etc..) as these are times that can see an increased level of noise in the movement of price.

Understanding the longer-term trend or momentum of the market is important because chart patterns which are counter to the direction of the underlying momentum are less likely to be profitable then patterns which form in the same direction as the momentum. Now obviously longer-term is relative to the the frequency that one trades, if ones makes trades based on 1-minute charts then longer-term might mean just a day, if one trades on 5- or 15-minute charts, longer-term could be a few days to a week, while if one trades on daily signals, longer-term would be measured in weeks or months. However, whatever longer-term means for the individual trader, longer-term momentum can be determined by examining charts of a longer periodicity. A trader need not make determining the longer-term momentum too difficult or complex a task, but instead should find a simple method that works for them. For example, this could include things such as examining the slope of moving averages, moving average bands, or the relationship of previous peaks and troughs in the movement of price (the idea being that if one sees consecutive higher highs (peaks) and higher lows (troughs) they are in an uptrend, opposite for downtrend). Essentially what the trader wants to do is to be able to with a fair degree of accuracy, determine whether the momentum is up, down, or sideways (range bound) and tailor their strategy accordingly keeping in mind that when the momentum is strongly upward, long trades are more likely to be profitable, and when the momentum is strongly downward, short trades should be preferred. Obviously there will be times when discerning the momentum is quite difficult, especially during times of high-volatility, or at times when the market is switching from one underlying momentum to another, but even not knowing provides the trader with useful information about how they should react to price patterns as times of high volatility and uncertainty are often good times for day-traders to be on the sidelines. However, the longer one studies and works on the market the better they will become at identifying the underlying momentum and its associated strength which will greatly improve their trading performance.

Along with being aware of the longer-term momentum of the market, a trader can improve their ability to enter trades that have a higher probability of producing a profit if they are aware of times when significant economic or earnings announcement are going to be made. This is important because after a significant announcement the market will often see an increased level of noise (or in other words meaningless price movement from the point of view of technical analysis patterns and indicators) and as such when a trader is aware of an impending announcement they can be better prepared to react (or not react) in a suitable manner. Too often technical traders are of the belief that the chart will tell them all they need to know, and while in one respect they are correct as the price of a financial instrument does reflect the aggregate market psychology of all participants (more on this in these articles here and here), the fact of the matter is that not all price movement is as valuable to a technical trader and times following significant announcements often produce price movement which is extremely difficult for even the most experienced traders to correctly interpret. For example the following chart is a 5-minute candlestick chart of EWZ (an ETF derived from the MSCI Brazil Index) from September 23rd 2009 which was a Federal Reserve rate announcement day, the first chart shows the movement of price that day up to 5-minutes after the 14:15 announcement, so up to 14:20.

Now if one were unaware of the Federal Reserve announcement they would likely believe that the price movement on this chart was very bullish and provided a good entry level due to the fact that price had formed a bullish price pattern known as an ascending triangle, and furthermore at 14:20 (candlestick represented by blue arrow) price broke out of the triangle and at the same time closed at a new daily high on a strong bullish candle. However, a trader who was better prepared and was aware of the Fed announcement would hopefully have realized that after significant announcements market participants need time digest the new information and conflicting opinions and emotions can lead to very volatile, noisy price movement which unfortunately in many cases traditional technical analysis can reveal little about. As the chart below shows, any trader who entered long based on the break out of the ascending triangle was in for a disappointing remainder of the day as price quickly turned sharply down for the remainder of the trading session.

To conclude, in order for a day-trader to have any chance at consistent profits over an extended period of time using technical analysis methods it is essential that they abandon the notion that it is as simple as just identifying and entering with the formation of each and every chart pattern. Instead one must learn how to distinguish between patterns that have a high probability of leading to a significant price move in the expected direction, and patterns which are nothing more then noise or in other words price movement which technical analysis has no business interpreting. While a trader who truly finds success will no doubt discover a unique method of their own to achieve this, the two ways mentioned above are simple but important initial stepping stones. Knowing the longer-term underlying momentum allows a trader to ignore some of the false patterns which form in the opposite direction of the momentum, while a trader who is aware of times when significant announcement are going to be made will be better prepared for times when the amount of noise in the market often greatly increases. For as the saying goes, if something is too good to be true, it probably is, and this is definitely the case for the simplistic picture of technical analysis that is too often painted in so many introductory books.