I’m going to say something that will make me sound crazy:
Technical analysis works.
Those three words have enraged academics and conservative investors since the dawn of momentum trading. Markets are supposed to be efficient. Stocks are meant to go on random walks. After all, when was the last time you saw a chartist billionaire?
But let me tell you this: I’ve seen technical analysis in action, and it works better than you expect. That’s because markets are made up of individuals with emotions. And in assets that lack high-frequency traders, you can exploit these inefficiencies by knowing how people think.
In this guide, I’m going to introduce the concept of the Momentum Master — how you can use technical analysis to gain an edge over other traders.
Momentum Master: My No. 1 Secret to Getting Technical Analysis to Work
You rarely see people win at charting because they’re fighting against billion-dollar hedge funds run by brilliant math professors. These mega-firms have trading algorithms that can front-run trading decisions down to the millisecond; individual traders don’t have a chance against them in foreign exchange, fixed income or large-cap stocks.
But what about meme stocks, cryptocurrencies and short squeezes? No algorithm can predict what retail investors will do to a $5 million Sh*tcoin. And even if a hedge fund found a working strategy, implementing it would make them look like the Loch Ness monster trying to hide in a kiddie pool. You can’t fit a $1 billion investment into a $5 million coin.
That leaves room for Momentum Master trading: the three technical analysis rules I use to gain an edge over other traders.
Let me give you an example of it in action. When I first started trading commodities at my first job, a broker called me to ask how I could always pick the bottoms.
Answer? I considered where traders put in their stop-loss orders.
No trader wants to close out in the red, so they will often place sell orders right above their entry price. The moment markets fall, boom! The sales get triggered at a 5-cent profit. A quick-thinking trader would use a simple technical analysis rule to trigger sales before others do. (There, now you know how to trade cotton futures too).
The Three Rules of Momentum Master Investing
Momentum Master Rule 1: Don’t Overcomplicate
You’ve probably seen chartists draw triangles, support levels, “head-and-shoulder” patterns and the like.
Throw that all away.
In technical analysis, only two patterns matter.
Mean-reverting. These include RSI (relative strength index) and other “reversion” strategies to play assets that gravitate to a central price.
Consider agricultural commodities such as corn or wheat. If the price goes too low, farmers will plant a different crop. And if corn somehow goes to $1 million per bushel, you can be sure that I’ll be growing it on every spare inch of my garden. Arbitragers use variations on this strategy to profit from price variations.
Breakout-seeking. These include SMA (simple moving average) strategies, Bollinger Band breakouts and other patterns that assume an acceleration of price changes.
These are momentum assets (I’ll call them Momentum Masters in upcoming emails), which tend to have no fixed value. What’s a Van Gogh painting or an 1869 Chateau Lafite wine worth? No one knows — its value depends only on how much the next buyer is willing to pay. These are great assets to identify early and hold for 1,000x gains.
So, why do most unsuccessful chartists lose money? They use the wrong strategy. Using a momentum-seeking approach on a fixed-cost asset means buying at peaks and selling at troughs. Making the opposite mistake means selling a Picasso for $5,000 during the artist’s early years and missing out on multi-million gains.
You get the idea. Use the right strategy — and don’t overcomplicate.
Momentum Master Rule 2: Read Rule 1.
Let me prove how simple things can be with one of our favorite Moonshot investments, Dogecoin (CCC:DOGE-USD).
The Shiba-Inu-themed cryptocurrency has confounded Wall Street analysts for years. How could a joke cryptocurrency with no real value become worth billions? Yet, meme after meme, the coin has become one of the most popular altcoins of the retail investor world.
What strategy should we use?
If you said “mean-reverting,” it’s easy to see why. Dogecoin gets “mined,” and fans are pretty vocal about buying on dips.
But that’s not quite right. Dogecoin’s cost of production fluctuates with its price. And given how little DOGE currency is used in the real world, there’s no anchor point to the U.S. dollar that investors can exploit.
Here’s what happens when you use the wrong strategy to play Dogecoin. (In this case, I’m using the RSI-14, a mean-reverting trading strategy)
Technical analysis fails when you use the wrong strategy…
See what I mean about using the wrong approach? You’ll pick up the small gains when DOGE trades flat, but you’ll miss out on the 100x upside.
Momentum Master Rule 3: Use the Right Rule
If you had instead used a “breakout-seeking” strategy, then you’d be right! Dogecoin tends to go up when investors get excited about the currency and fall when people lose interest.
…but shines when you use the right one.
That graph is more than seven years of data, so there were plenty of signals during that period. Let’s take a closer look at a smaller nine-month slice for some detail.
Catching the gains, selling before drops.
The simple SMA-50 strategy would have caught all four of Dogecoin’s big breaks in the past seven years. Someone who bought and sold at every signal — both false and real — would have turned $1,000 into $19.1 million. That far exceeds the buy-and-hold strategy of $429,500.
That’s because the breakout-seeking strategy also tells you when to sell. Because cryptocurrencies also break lower on the downturns, the disciplined approach to profit-taking means locking in gains for future investments.
Simplicity in the Making
Let me tell you a story:
A multi-million-dollar luxury yacht stalls out, and all the junior mechanics spend hours failing to figure out what’s wrong. Finally, an old mechanic comes up, taps the engine with a hammer, and the yacht’s engine roars back to life.
“That will be $10,000, please,” he tells the ship’s owner.
“What?!” Exclaims the luxury yacht owner. “You hardly did anything at all!”
“Well, that was $2 for the work done and $9,998 to know where to hit,” the mechanic smiles.
I want you to notice that I’m not using a single complicated formula here. SMA-50 means buying whenever the price has moved above its 50-day average and selling when it falls below. We’re using a proverbial hammer here, not some 20-factor time series equation.
I’m not saying complex equations don’t work. Jim Simons of Renaissance Technologies built a $165 billion hedge fund thanks to his years of experience as a Cold War codebreaker. Millennium Management, Bridgewater, Jane Street and other shadowy Wall Street firms scour financial markets for similar “whispers” to exploit.
But the only complicated thing we’re doing is knowing when to use our strategies. Most alt-cryptocurrencies are breakout-seeking assets, so we’ll use an SMA-50 system to identify winners. Meanwhile, mainstream crypto trades like dollar-based Tether and the Kimchi premium (i.e., the temporary Bitcoin price differences on the U.S. and Korean exchanges) are naturally mean-reverting. Many “boomer coins” will also start mean-reverting as they start getting reference values in real-world use.
Some Drawbacks of Technical Analysis
Notice how I don’t use technical analysis for anything besides understanding sentiment. I don’t pretend that rising prices make the underlying asset “good” or “bad.” That’s how professional chartists get into trouble. Instead, I view technical analysis as an impartial tool that stacks the odds slightly more in our favor.
There are also some downsides to these strategies.
First, charting strategies usually say nothing about doubling down. Consider cryptocurrencies that crossed their 50-day moving averages a month ago. SMA-50 doesn’t tell you if you’re too late to buy.
Second, moving averages and other indicators need time to establish a baseline. ICO coins might have strong momentum, but they won’t have enough trading days yet to draw a pattern.
Finally, charting can fall flat on its face (i.e., don’t bet the farm). No rule says a cryptocurrency must keep going up or down — you’re using a tool that swings the odds a couple of percent in your favor, not an “I win” button.
Closing Thoughts: The Yins and Yangs of Charting
Many years ago, when I was in college, I signed up for a finance course.
On the first day of class, guess who showed up. It was Professor Burton Malkiel himself, the author of the famed book A Random Walk Down Wall Street.
It turned out I had signed up for a course taught by the guru of the efficient market hypothesis!
Yet, many people don’t realize that Dr. Malkiel also authored countless papers on the market’s inefficiencies. Why should closed-end funds trade at a discount to net asset value? Or why does the average hedge fund produce negative risk-adjusted returns? (If markets were efficient, underperforming high-fee hedge funds theoretically cease to exist).
The dichotomy highlights a beautiful fact of finance. Markets are usually efficient, but not always so. Smart traders can find unexploited inefficiencies to make money.
That’s because humans aren’t perfect information-processing machines. We’re powered by the excitement of gains and the pains of losses. We get hungry. We get sleepy. And we get tired of reading how-to articles.
So just know this: technical analysis works. But just like a hammer, these indicators are only helpful when you have a nail to hit or a yacht to fix.
On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.