With the rapid advancements in computer and internet technology, technical trading systems are one of the more realistic means an individual trader has at obtaining long term market success. A technical trading system can be defined as a set of rules, based primarily on the movement in the price and volume of a financial instrument(s), which are followed to make decisions on when to enter a market position (long or short) and when to close or exit a position. A technical trading system does not necessarily have to be a set of rules that can be automated and executed by a computer, but can involve human judgment (i.e. drawing trendlines or detecting chart patterns). To be successful investing in a traditional manner (i.e. fundamental analysis) requires access to significant amounts of information about individual companies, sectors, and the overall economy, which is sometimes difficult for those who are working on their own to obtain in a timely manner. However, developing and trading a technical system only requires access to historical market data for the development of the system, live data for the trading of the system, and a computer program to develop and test the rules of the system, and these things are all easily accessible to the average trader.
While the basic requirements to develop and trade a technical system are relatively minimal, this does not change the fact, but instead contributes to it, that the overwhelming majority of technical system traders do not succeed in their quest to become profitable. While this can certainly be attributed to a wide array of factors, a primary one is the misconception that one can develop a technical trading system that will earn them money for as long as they care to trade it. Often individuals will begin developing a system with the belief that once they have found the right set of rules essentially their work will be done and they can then just sit back and watch the money roll in. Traders who stick to this view will never find a system that performs in the manner they desire. Even systems that see profitability initially, if they are not adapted over time to the periodically changing behavior of the markets will eventually reach times where the performance of the system is so poor that trading it is not wise or in some cases (due to the losses produced) not possible for very long. As such a technical system trader must realize that success over the long term requires constant work and testing in order to properly adapt ones rules to the evolving financial markets.
The changing psychology of market participants is what drives movements in the prices of all financial instruments. Changes in the aggregate psychology of market participants is influenced by a wide array of factors including things such as economic and earnings reports, political events, natural disasters, pandemics, and levels of pessimism or optimism among individual investors to name but a very few. While fundamental analysis concentrates on a limited set of these influences (primarily earnings reports, financial statements and economic data releases), technical analysis on the other hand is so powerful because by focusing on changes in price and volume one is paying attention to the only two factors which reflect the collective beliefs, views and emotions that all market participants have towards a financial instrument. (More on the relationship between market psychology and technical analysis can be found in this article). While the power of technical analysis comes from it focus on changes in market psychology, this focus is also the reason why one set of technical rules cannot be profitable forever. To be more specific while the composition of factors that influence the psychology of market participants may stay relatively static over short periods of times, in the long run these factors inevitably change, sometimes slowly, other times rapidly as the economy evolves, human knowledge expands, technology advances, and even as investment methods change.
Obviously the largest influence on market psychology is the overall performance of the economy and there is now an increasing amount of evidence that the economy is a complex adaptive system (more on this here). Essentially what this means is that over time the economy will not inevitably drift to equilibrium, like traditional economic theory suggests, but will instead display a wide range of behavior such as exponential growth, radical collapse, and even oscillations depending on the interactions among individual agents in the economy. Thus as the behavior of the economy changes so to will the patterns of price movement which form as a result of investors reactions to this changing behavior. Some proponents of technical analysis will argue that while the influences on market psychology are evolving over time this does not change the way one should interpret price movement as the same chart patterns and indicators will continue to work in the same manner. While this is partly correct in that technical analysis as a whole will continue to work, it does not take into account the fact that over time the success of different individual technical analysis methods will vary greatly and if a trader wants to have continued success they must adapt their system from methods that are not working, to ones that are. The reason why techniques vary in performance over time is due to the fact that most technical analysis methods are very sensitive to the level of volatility in the market and as the influences that dominate market psychology evolve this leads to changes in market volatility.
The best way to determine the role that volatility plays in the performance of trading systems is for one to discover it themselves. This can easily be done by coming up with a set of trading rules and then testing and recording the results of the system over historical periods of time that have seen different levels of volatility. A strong recent example would be to first test the selected rules over the 6 month period from September 2008 to February 2009 when volatility levels were very high, and then over a six month period in a year like 2005 or 2006 when volatility levels were much lower. In doing this one is likely find is that the performance over these two periods differs significantly, and more importantly differs in a manner traders would not want to experience in their own trading accounts. Volatility plays such a big role in the performance of technical trading systems because technical indicators, chart patterns, levels of support and resistance, moving averages, volume patterns, along with virtually all other technical analysis components perform much differently during times of high market volatility when levels of fear and greed are elevated versus times of lower to moderate levels of volatility. Some may be inclined to point out that the volatility in late 2008 reached unprecedented levels and as such those levels are unlikely to be seen very often, however, this a very risky guess to hinge once success on, especially given how easy it is to have ones entire capital base wiped out if one leaves their success to luck and guesses.
Realizing the importance of periodically adapting ones system is the easy part, knowing how and when changes to the trading rules are warranted is much more difficult. Traders struggle with this problem constantly and it is one of the things that determines the difference between successful traders and unsuccessful ones. Successful traders make rule changes only at times that warrant them, understanding the reason for the rule change and why it should improve their system. Unsuccessful traders either never change their rules because they are scared that if they do they will miss that next 'big' trade, or on the other side of the spectrum constantly make changes to their system with virtually every new idea that pops into their head. While only hard work and experience will allow a trader to reach the happy medium, there are certainly a few things traders can do to improve their ability at making optimal changes to their rules to fit the evolving financial markets.
First of all it is essential to be able to determine times when the performance of one’s system has begun to see a significant change as these times often signify the possibility of a changing market environment. For this reason it is essential to keep detailed records of one’s trading statistics (i.e. dates and levels of entry and exit, profits and losses, and reasons for entry or exit) as in doing so one will be better prepared to notice performance changes. Secondly, a trader will be better prepared to adapt their trading rules in an appropriate manner if they test and explore new methods not only during times when their system is performing poorly, but also during times of strong profitability. The constant work will provide the trader with a larger plethora of ideas on how to change ones rules to better fit a new trading environment. Also in general a trader who is constantly exploring and testing new ideas will have a better intuition of when they have discovered a rule change that will improve their system’s performance as well as what methods work better in the various trading environments they may encounter. Finally, a system trader will benefit immensely in their success at evolving their system if they not only pay attention to the group of financial instruments which they trade, but also to the price movement of all the main global markets (i.e. sectors, countries, indexes). An easy way to do this is to periodically examine the price charts of say the twenty to thirty exchange-traded funds with the highest volume as collectively they encompass the main sectors, industries, global economies, and stock market indexes from across the globe. Doing this is extremely beneficial as a trader will provide themselves with a better chance of detecting times when market psychology may be changing to such a degree that the associated market volatility will also change as often there are a few individual markets which see the change before it spreads throughout the economy (i.e. real estate and financials preceded the 2008 change). For as the saying goes, time is money, and the earlier one detects the possibility that some rules will need to be changed the better.
To conclude, technical systems offer great potential for traders to achieve long term market success, but only if they are developed and used correctly and in reality only a relative few ever gain this ability. However, for those who hope to achieve this success it is essential that they understand that a profitable trading system is never a finished product, but always a work in progress. This is due to the fact that the composition of factors which influence changes in market psychology are always evolving and this leads to changes in market volatility levels. These changing volatility levels result in different technical trading methods performing better or worse and as such a system will only see long-term profitability if the rules are adapted to these changes in the market environment. The greatest difficulty for even those who are aware of the need to periodically change ones trading rules is determining when rules changes are actually warranted. All too often traders fail because they either never change their rules or at the other extreme change their rules too often. But fortunately, or unfortunately, depending on how you look at it, the only way to obtain the skills, intuition, and knowledge required to be a successful trader is with continued hard work and an open mind.
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