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Sunday, 16 September 2018

DOES TECHNICAL ANALYSIS WORK? WE PUT IT TO THE TEST WITH SKPRES

We recently received a lot of queries on how to use technical analysis for trading. They range from the mundane - figuring out double bottoms and dojis - to the exotic - figuring out if the tides and moon phases mean that it's now time to buy a million MYEG shares (OK, we exaggerated a bit, but you get the point).


We're completely fine if you stop reading this post now; this sums it up. Source.


We have some strong opinions about technical analysis and the practice of charting in general, but bear in mind where we are coming from. Think of our philosophy as more myopic - it's from the perspective of a trading team that has done the following over the past year:


1) Conducted at least 100 trades, with different thematics, and different profit targets.

2) Realised the occasional five figure profits on a trade, and the occasional five figure losses.

3) Conducted sizeable trades, with total turnover of stocks worth at least several million ringgit a month.

4) Concentration on price and volume activity, over all other indicators.

5) Substantial exposure in high volatility situations, and sentiment based trades, which we consider to be our key competitive advantage.


Our readers and Twitter followers tend to ask us this : what's the best indicator for trading the kind of stuff that we usually go into? (Editor's note : we had usually gone into (4) and (5) in recent months. We are wary of long term positions right now because of the jittery broader market).


The answer may surprise you: we don't use technical analysis at all - at least not the fancy indicators and wacky terms. We can tell you now that things such as RSI and moving averages are completely useless. And we largely agree with this guy who says that technical analysis to trading is what astrology is to science.


But we do utilise their applications in our beliefs and understanding of market psychology. In other words, we don't use TA but we absolutely believe that most investors put a lot of faith in them. This helps us in anticipating possible entry and exit points; we always try to wrap up our trade before the rest of the market does, even if it means losing out on larger profits as you will see.


We will demonstrate the shortcomings and advantages of TA using a recent trade. But we're not trying to repudiate an entire school of thought and legions of technical analysts who work full time at banks. We're just saying that this approach does not work for us; we've been researching this extensively over the past 5-6 years and we concluded that our way is better for our own style of trading.


But first, a little rant about TA and why it's bad for you and your wallet.


BETTER TO LOSE RM1,000 FROM TRADING THAN PAYING THE SAME AMOUNT TO ATTEND A COURSE


In this country, we are saddened to note that most thought leaders and seminar speakers tend to preach what they claim to practice, instead of the other way around. The easy money is not made by trading, or putting their money where their mouth is, but by charging for overpriced 'introductory' courses on stocks, as well as technical analysis.


We have heard from a large number of people who paid RM5,000 and above to attend a weekend course on what was purportedly called 'the basics of technical analysis'. They later found out that the same information can be gleamed from books on technical analysis costing RM50 or less. Even worse, some courses go to great lengths to promise instant profits, an exponential increase of your capital at low risk, and worst of all, explicit tips to buy lousy penny stock companies.


(Editor's note : this is why this blog will never try to market our expertise or charge fees to get special access, whatever that means. We do not run a syndicate or try to influence people by front running them in Whatsapp/Telegram chat groups. Some blogs do these things, so be very cautious. We're OK with making money from our trades alone - practising what we preach - and sharing our knowledge here, free of charge, because we love you.)


 Some seminars can make a monkey out of investors. Source.


Let us put it this way:


1) If the technical analysts were so good, they would have traded on their own ideas and make hundreds of millions of dollars as money managers, not by peddling seminars and getting people's hard earned money as fees.


2) There is no such thing as instant profits or an immediate multiplication of your capital right after you attend such seminars. But we see this being promised all the time.


3) Don't believe the grand claims made by these people ('I predicted the 2008 crisis', 'I bought gold at USD100 per ounce', 'I bought Bitcoin at 15 cents') unless they have direct proof, and the wealth to show for it. The last thing they need to do is conduct pricey seminars to pay the bills, unless they're full of shit, of course.


What we recommend instead:

Don't judge a book by its cover; we think it has a dumb title, but the content got us hooked. We would not be any good at trading if we hadn't read this. Link to buy.


1) Buy a couple of books on technical analysis and use Google for everything else. We dare say that you will get results that are better than if you had paid thousands of ringgit to attend a seminar.


2) Test out your own set of beliefs, using your own money, at your own discretion. If you're into TA, find an indicator that works for you. Don't be afraid to make mistakes and lose money. Proper trading and risk management comes from real life trading and from making mistakes, not from a weekend seminar. We also have to note that paper trading and virtual trading can only go so far; you have to learn how to actually trade and lose real money, and develop from there.


3) Never, ever, take stock tips. Always do your own analysis. If you take 30 minutes of each day to focus on trading, each week you would've done 3.5 hours of solid homework. You can get ideas everywhere - hopefully by reading this blog, too - to start with. Did you know that in this country (Malaysia) we are blessed with easy access to all sorts of stock research reports at no cost?


4) Attend free seminars instead, such as the ones organised by Bursa Malaysia and many investment banks from time to time. You may be strong-armed into opening a trading account, but that's nothing compared to reminiscing over that RM5,000 that you just wasted on seminars.


We're not anti-learning, but we are against unscrupulous operators who charge people hefty fees for information that is about a hundred times cheaper. Especially those who prey on people's hopes and expectations of easy riches.


Now on to our second sort-of rant.


TECHNICAL ANALYSIS WILL ALWAYS BE IMPERFECT


In the past, we admit that we too have been avowedly anti-TA. We used to completely reject the notion of using past performance to determine the future outcome of stock prices. We were also mildly amused by the colourful terms associated with chart patterns and candlesticks - we still are, actually. Do let us know if 'Abandoned Baby' has helped you reap tens of thousands in profits.




And yet, we have encountered situations where an understanding of technical analysis, in relation to market psychology, has helped us greatly in our trades. We do obsessively look at price charts, probably like most of you, but we don't assign any significance to most indicators, except for a couple. We will share them here.


Note that our findings have helped our own trading activity. We only speak from experience and our own painstaking research. Like everyone else, we really wanted to gauge the effectiveness of TA, but our philosophy is based on what works for us. We've looked at TA applications in more than 400 trades that we've executed - sometimes they work, sometimes not.


Our personal viewpoint is this : TA is important, but not as important as most people think. Our focus on TA is the chart and what it represents, not the silly terms and indicators. We value risk management and trade execution as far more important considerations in trading. TA is also a real time visual representation of market psychology, and this finding alone has helped us derive large profits. Ignoring tTA has also cost us greatly past trades as we did not react fast enough to save ourselves from steep losses.


If anything, we urge people to learn TA as a tool, not as gospel. It helps greatly in understanding charts and price movements. It can never be relied on as a 100% surefire money making tool, but the reality is that most investors still see it as such. Most importantly, please don't pay stupid sums of money to learn this.


 THE SKPRES TRADE : WHERE TECHNICAL ANALYSIS WOULD HAVE HELPED


We love to trade the stocks of fantastic companies that are hitting new lows. We have made up our mind up about SKP Resources a long time ago (Editor's Note : we stand by our analysis but remain horrified at the same time), and we do not fundamentally see it as a loser. But the market currently does, hence this year's long term decline.


We were wrong about the stock's near term price potential, but we still see is as a fundamental winner. The market reacted badly to expectations of lower profits and lower margins on a quarter-to-quarter basis, but ironically, for a team of traders with a short-termist philosophy, we see SKPRES as a long term winner.


We do not care if the profit margin falls slightly from 10% to 8% q-o-q; if we see profit-beating margins and a sector leader, with a proven business growth trajectory, low debts, and great cash flow, any stock price decline is a buying opportunity for us. SKPRES is one of those companies.


[Editor's note : there are loss making companies that have held up better than fundamentally solid ones this year. It underscores our concerns about the current disparity between value and sentiment, and how we might be facing the next stock market apocalypse soon ;) ]


At the same time, it is also possible to utilise a short term trading viewpoint to express our long term views. Let's look at a recent trade on SKPRES, our thematics, and the relevance of TA in the process.



 Our trading period for SKPRES. (It's a contra trade)


SKPRES has lost half its value in market capitalisation since the beginning of the year - again, we can name lousy, loss making companies that have not experienced this - even though it's still showcasing steady profits, if not consistent profit growth. We have to note that earnings from contract manufacturing orders tend to be lumpy at times, so it's unrealistic to expect constant earnings growth. 


After a recent, particularly bad run of price declines, we found that the stock offers attractive short term rebound prospects - we've done similar trades before, so our conviction was somewhat strong. We spent a few days just looking at the price decline - they were rapid and occurred at low liquidity, amplifying the stock's fall. We sensed signs of desperation somewhere; perhaps a large shareholder was trying to dump the stock quickly at all costs.


SUPPORT POINT


So one day the stock hit below RM1.20, signifying what is known in TA as a 'double bottom'. Simply put, it's the lowest point the stock has been for a long time. A double bottom is (supposed to be) a strong price point. A trader who uses TA may be inclined to load up on the stock at that price point, in anticipation of a brief but potentially highly lucrative rebound.


That's pretty much exactly what we did; we used TA, but in the context of how the market will perceive the stock. We loaded up on the stock at RM1.18, RM1.19, and RM1.20 at first. We bought more at RM1.22 and RM1.23 as it began meeting our expectations of a short term price recovery.


SKPRES 19-month daily price chart. Notice the Double Bottom, indicating that RM1.20 is as good an entry point as any.


 RESISTANCE POINT 


Our holdings, at an average price of RM1.21, went up to RM1.25 within the contra period. At this point we stood to gain RM5,750, or a 3% gain; a fantastic return for a 'no-money-down' trade. But we were actually aiming for the RM1.30 mark, which would by now be seen as the 'resistance point'.


Ideally, we'd have liked to sell as the market begins pushing up the price. We had hoped to sell at the RM1.28-RM1.29 mark, just before buying sentiment peaks at RM1.30. Resistance points are exactly that; heavy selling pressure is expected at that price point due to the recent price weakness, as well as from short term traders that are eager to sell (people like us).


We thought long and hard about holding on to this position until it hits RM1.29, which would have netted us an additional RM5,000 or so in profits. But we decided to sell at RM1.25 and exit the position.


MOMENTUM INDICATOR 


For us, charts are just visual representations of things we prioritise the most; price and volume activity. We dictate our entry points, exit points, profit targets, and stop-loss thresholds.


Our exit at RM1.25 on 3 September signified a somewhat conservative approach when we could have alternatively decided to ramp up the position. At this point, the contra angle no longer applies since our expectations of momentum have been met.


When SKPRES hit RM1.25 we were presented with two options:


1) Sell the entire position and lock in a 3% gain.

2) Keep the existing position and risk some downside volatility with a RM1.29 profit target price.


We also had another option that is far more aggressive: keep the entire position and double the amount of stocks held by buying as much as we can at RM1.25. If we commit to this, we have to be willing to lose that entire RM5,750 in profits if the trade went south. But the upside potential made it an appealing proposition; we stood to gain as much as RM11,000 if the stock hits RM1.29.


You may ask: how or why would we decide to buy so much at RM1.25? This is because we had set an expectation even before entering this trade. Think of it as part of a decision tree, or one of those [either/or] commands in computer programming:


RULE X : If SKPRES hits RM1.25 within the contra period, there is a high likelihood of the stock advancing all the way to RM1.30 and above in the subsequent few days. If this happens, sell at RM1.29 just to be safe.


We decided against doing this due to the negative broader market. A high risk, high reward momentum trade is more palatable when the broader market is also positive; the broader positive sentiment tends to ignite more enthusiastic trading activity. This particular period wasn't one of those days.


There were elements of technical analysis that we depended upon, and in this instance everything went well. The technicals supported our view of the stock, and we missed out on more profits.


It turned out that RULE X was worth its weight in gold; SKPRES hit RM1.25 within the contra period, and the stock advanced to RM1.30 in the subsequent days. In fact, it went all the way to RM1.34, proving that we underestimated the momentum.




We are pleased either way. It's not the eventual profits that matter the most to us; it's the execution as well as the information derived from the whole process. We identified a stock and indicators that are useful for making money. The next time we encounter a similar situation we hope to be better in our execution, and we will not discount the value of TA.