Re: TA doesn\'t work?
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> I'm trying to understand here. If, as you state, low RSI points
>will coincide with bottoms in price, then buying at low RSI points
>should work to the same extent as a strategy of buying at price
>bottoms (or at least after price declines since nothing can call an
>exact bottom).
Well, this is the biggest problem with technical analysis as it is
applied: People look at big, major bottoms in stock prices and
notice that the RSI was below 30 or 20 or whatever every time.
So they convince themselves that the stock is near a bottom when the
RSI gets below 30 or 20.
This is one of those things that I've spent a lot of time testing.
We thought that if a stock is oversold with an RSI below 30, it was
even more oversold under 10.
As you can imagine, if you look at ALL instances, then the results
were random.
In fact, many people even developed trading systems based on BUYING
stocks/commods when RSI goes above 80 and SELL them when they go
below 20. Of course, this worked really well in strongly trending
markets.
Like many other of these simple systems, all one needs to do is to
predict whether the market/stock in the future will trend strongly,
or be stuck in a trading range. Then we can pick the appropriate
system to trade!
In the short term, market price movements are actually very close to
being random. Most of the tests I've done (with the best database
and the best software (and full time programmers) in the business at
the time) showed that to be true.
No matter what condition you looked at, price would be up or down
50% of the time on a daily, weekly or even monthly basis for most
stocks and commodities. Even if there was a divergence in it, the
number would be 51%, 52% or maybe even as high as 55 or 60% (but the
samples would be much smaller in these cases). Hardly anything to
be able to trade off of).
Now, this is not a refutation of TA or the RSI as an indicator, but
it is illustrative of the sort of self-deception or illogic that is
prevalent in the business. It is amazing how many intelligent
people don't understand this simple concept (of course, quants
understood this well):
The argument was:
Technical trader: "Man, this stock has been down for the last 10
days in a row! It's gotta bounce tommorow! What are the odds that
this stock can go down 11 days in a row!! Very low!!! This is a
great high probability trade!"
Me: "No, no, no. The odds of the stock being up is still 50%."
Technical trader: "No way, it's gotta be higher than that! What are
the odds that the stock could be down 11 days in a row?".
Me: "That's a different question and has nothing to do with what the
stock will do tommorow. The odds of a stock going up or down 50% is
not effected by the fact that the stock was down for the past 10
days... "
Technical trader: "Why not? The odds of a stock going down 11 days
in a row is highly unlikely, and if the stock declined tommorow,
that would be make it a highly inprobable event..."
Me (exasperated): "OK. What about if it was a coin. We flipped the
coin 10 times and it came up heads. What are the odds that the coin
will come up heads on the next flip?"
Technical trader: "Same. 11 heads in a row is highly unlikely so it
can't be 50%"
Me: "OK. never mind."
--
I actually had a conversation like this with a trader. It was
unbelievable. And yes, we did test the odds of a stock moving up or
down after all sorts of 'runs' (what happened after 10 up days in a
row etc...), and the results confirmed my point. It was usually
50/50 no matter what kind of conditions you put on it.
(by the way, the only time you get extreme results is when you have
very few data points. If you put so many conditions on, then it
reduces the number of occurences and hence the figure may deviate
from the 50% level. At that point, you don't have enough 'events'
to call your results 'significant').
Anyway, the above thinking, that a stock must move up since it went
down so much is at the heart of the RSI / Stochastics type
indicators. It might be a little different, but the basics of the
argument is exactly the same.
Another one of these silly indicators is the Bollinger band type
things with standard deviations. You put bands around a moving
average or something so that you can say when a price overshoots
outside of an average to 2 standard deviations whatever, "the stock
price has been in this area only 5% of the time! So it must revert
back to the mean at this point. You have a 95% chance of making
money on this trade!".
This suffers the same fallacy, because there are two ways that a
stock price can revert back to the moving average. The stock price
can come back down, or the moving average can move up and catch up
to it.
In these books, they will always show you the charts where the
argument looks compelling.
But this type of analysis also suffers from the same thing as the
RSI, stochastics. In strongly trending markets, you want to get
LONG when a stock price hits the upper standard deviation bands, and
sell or short when they hit the lower ones.
But then again, you have to know beforehand if it's going to trend
strongly or be stuck in a range.
That's why these things are useless. If you knew what you needed to
know to make these indicators useful, then you wouldn't need the
indicators!
If you have a sense of humor and a lot of patience, it's kind of fun
to work with these guys. (even though I've lost patience for this
nonsense long ago...)
> Anyway, I like to look at RSI (as one of many other factors)
>because I think buying on price dips is a good strategy. It may be
>pseudoscience but it gives me a signal to look at it besides just
>the line falling on the chart. I'd be open to other strategies for
>buying on price declines.
You can use these technical indicators for whatever you want, but
just don't expect it to mean anything. That's all. It's true that
it can be psychologically comforting (OK, let's ask Munger what he
thinks about doing something for psychological comfort at the
expense of logic and rationality!)
A good strategy for buying on price declines is to keep a
spreadsheet of intrinsic value of the companies you follow and a
threshold where you might be interested in buying it. And then
buying it when it gets to that price.
I think that's a great way to go.
But I would never buy something on an RSI or stochastic or anything
like that. I know it's psychologically appealing. When you see
that thing stuck down there under 20 for a long time, it's natural
to think "man, this stock's GOTTA bounce. It just HAS to!".
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