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To begin with, pardon my amateurish question. I'm not into trading whatsoever, hence the following text doesn't represent practical expertise, it's based upon a train of thoughts and various sources I've encountered over the last couple of years.

How are technical trading patterns working?

Literally, I'm skeptical. I've always been told that there is basically no way the stock market can be predicted whatsoever. The main point is to spot recurring patterns - though why aren't the odds 50/50 that the price will go up/down at any given point? For example, experts are stating that if a "Head and Shoulders" pattern occurs, the chart tends to go down at the end, but statistically speaking it may as well go up in the end. The premise that this pattern works as we're specifically looking for it. For me, it seems that's the case of Survivorship bias: We're only looking at the cases that fulfil the tendency we had to begin with.

Furthermore, in case there are actual technical patterns which work at least 50%+, why aren't there people literally making unlimited amounts of money? I've heard and read of high frequency trading, AI trading and consortes, though with those in place - if I set up a programme to analyze any given amount of stocks / forex charts, etc. for just the "Head and Shoulders" there wouldn't be any way to loose money (even if the stop loss is the same for profit and loss; as we're making over 50% of the times right calls)...

So again, is this working? And if it is, how? What's the statistical and technical explanation? Isn't the system bound to crash and/or not to be predictable?

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  • $\begingroup$ @KeSchn Thanks for the mentioned thread - I took a look at it and it's in-depth and a good read, though it doesn't answer the whole part I was looking for. Especially, a.) Isn't the system bound to crash and/or not to be predictable and b.) (an inferred question) Why people aren't making unlimited money if such a method actually exists. $\endgroup$ – J. Doe Aug 16 '20 at 21:28
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    $\begingroup$ the paradox is the fact that the events in (a) and (b) empirically occur as a result of one another, that's why neither can persist. if (b) is happening than that means an inefficiency in the market is being exploited, but these don't last long. As more people exploit that inefficiency, it gradually disappears. or (b) the bandwagon overloads the market until the bubble bursts resulting in a freefall of all asset prices because human rationality, which could have provided predictability, is overrun by insatiable greed instead. feedback between a and b kills all models and perceived patterns $\endgroup$ – develarist Aug 16 '20 at 21:36
  • $\begingroup$ @develarist if I understand you correctly, you’re implying that it’s not possible to consistently predict the market with technical patterns and that on a long term every investment in the stock market is bound to fail somewhat. $\endgroup$ – J. Doe Aug 16 '20 at 22:07
  • $\begingroup$ yes, this is a common explanation against building trading strategies and why fundamentalists will deride technical analysts. there is also clearly more evidence, in the history of the stock market at least, supporting the view that patterns: can't and don't persist, were spurious upon inception, and therefore are quickly debunked. its better to use technicals as an aide for much stronger financial theories and policies that the trader has. Hedge funds who are making unlimited monies clearly are adapting their strategies hour to hour, not year to year. $\endgroup$ – develarist Aug 16 '20 at 22:17
  • $\begingroup$ My average Joe 'retail' opinion, which I'm sure that many will disagree with, is that technical analysis indicators can provide information like support and resistance, current trend, current momentum but they are a reflection of past price and/or volume movement and they predict absolutely nothing going forward. It's like looking in the rear view mirror and expecting that to tell you where you are going. Any trade that you take based on such analysis whether it be indicators or patterns is based on the HOPE that whatever trend or momentum you have identified will continue. $\endgroup$ – Bob Baerker Aug 17 '20 at 1:38
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Your scepticism is well-placed, even if there might be some information value in technical signals! Believing they represent an El-Dorado in the absence of understanding, let alone hard work and inevitable losses along the way, will always be the greater sin, irrespective of any potential value (or not) in the technicals!!!

So the "logic" behind technicals basically argues that in the short-term, price movements don't always reflect changes in market participants' expectations. Rather participants have already positioned in expectation before the news; so the reaction to the news has as much to do with this positioning, as with the surprise the news might represent. So, in English, the consensus for X might be 1.5% versus 1.4% last time and it realises at 1.6% but the market might sell off on this news, because everyone was already betting on the rise. There are no new buyers (all who wanted to buy have already bought); and plenty of sellers ready to take profits. So the market sells off (more sellers than buyers) despite the "good" news.

If you accept that there might be two levered buyers and two short-sellers for every cash-funded holder of X, then the thesis above need not sound so crazy.

Suffice to say that in a past life, I was well-paid as a sellside market strategist for 20 years to watch this happen in real-time; try to make sense of it; and explain it. Market behaviour is not, and was not, consistent with the randomness that the economics textbooks calls for. There was, and is, "something else" out there. This does not, of course, mean that technical analysis or "positioning" can explain, and fill this void...

So Technicals basically argue that the effect of positioning on prices in response to news leads to a tendency towards particular patterns of price action. Given these patterns, it should then (basic Bayesian inference) be possible to infer positioning. And thus a likelihood of a bias in price response to new news. It needn't be a big bias, let alone a certainty of direction of response. If you had a 45:55 every week, you could retire rich without having to get a job...

This hypothesis is almost impossible to prove, even to reject. Which is why Technicals remain so popular. The alchemist's financial "philosopher's stone" remains extant.

The problem with rejecting this all out of hand is equally simple. One can create very simple Hidden Markov Models of markets that differentiate between a "stable" state and a "chaotic one", where returns in the latter are lower for higher volatility. With p=values good enough to write a statistical paper, better than much of the medical evidence that informs policy decisions about Covid-19.

But the HMMs are "technical" in nature, no...? How does dressing this up in right-sounding modern statistical modelling 101 make it any more legitimate than talking about "head and shoulders" patterns? That is the real problem ;-)

To believe that the HMMs are spurious, you have to believe that there is NO effect on the distribution of the mean and volatility of returns in low-vs-high volatility regimes. Good luck arguing that one! Else you have to concede there are regimes where "greed" and "fear" (for want of better explanatory variables) do influence the distribution of returns. So sentiment matters. And if sentiment matters, there is indeed some technical dimension to asset returns. QED.

Where the limits of this process start and finish is where investing paupers vs poor retirees vs content retirees (who cruise a lot) vs millionaires/billionaires limits end up getting drawn, IMO... ;-)

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