Understanding the Head Fake Move: How Technical Analysis Went From an Asset to a Trap

I write nearly every day about a head fake move, a possible head fake move, a probable head fake move, how common head fake moves are before a reversal, etc. In fact I write about it so often, I almost get sick of typing the words and often wonder if you too feel like, "Oh, here comes the head-fake".

However, this isn't a theoretical phenomena, it isn't something that I "think" is happening, in fact it has nothing to do with me at all beyond the fact that I have observed so many that I know them pretty well.

First I want to tell you why I know what I do about head fake moves, a sort of history of their development, it will help you understand them more and help you learn to identify them, know when they are likely and use them to your advantage.

I have been in the market for about 14 years now, however my personality type is when I become engaged or interested in something, I really go overboard to learn as much as I can about it. I first started with Fundamental Analysis after reading several books, I quickly found that it didn't work for me, my opinion is it barely works at all for several reasons: 1) the market isn't about fair price, it's about perceptions, fair value has nothing to do with it. 2) To come to valid conclusions using Fundamental Analysis, you have to have accurate data to analyze the stock, how many times have we seen data that is clearly misleading or down right untruthful ( Global Crossing, Enron, Lehamn, MF Global, etc-these aren't small companies, they were giants and they spread untruthful fundamental data). 3) You have to believe you have an edge in analyzing the data, in fact you have to be better than the analytical departments of some of the biggest banks in the world with hundreds of millions of dollars invested in those department, the best minds with the best information and programs. Do you really think you can outsmart them analyzing a stock after you get home from work?  4) As mentioned above, the market has nothing to do with fair value anymore and fundamental analysis is about determining fair value and looking for stocks that are either below or above fair value to either buy or trade short, but look at the Tech revolution, look at the P/E multiples of companies that weren't even around a year-over 300! Look at the home-builders, were they really worth the prices they were fetching? Again, it's about perceptions, not value. There are many other cases to be made against fundamental analysis, but those are enough to convince me it's not useful.

After a string of horrible trades using Fundamental Analysis, I turned to Technical Analysis. At the time T.A was considered,  "Voodoo Analysis";  people made fun of Technical Analysis, saying things like, "Oh yeah, price crossing a line is a real metric of value" or "All of those lines you follow, do you also watch the lunar cycle or the Zodiac to tell you what to buy or sell?"

I remember this clearly, but I also remember it made a lot of sense to me, the idea was to figure out what the big boys were doing and then follow them and do the same, that is where Technical Analysis has it's roots.

THE SHIFT TO TECHNICAL ANALYSIS...

Almost overnight there were more Technical Analysis books than you could shake a stick at, something changed in the perception of Technical Analysis nearly overnight, at least it seems that way looking back. What was this shift? The Internet.

As soon as the Internet revolution became mainstream all kinds of things changed, low cost online brokers popped up and you could now make a trade for $7.00 instead of $80 that you use to pay to a typical broker. More and more people decided to start managing their own money, especially after a bear market in which their mutual funds declined in a huge way and they sold them right at the bottom for massive losses.

The problem for all of these new-would be traders and portfolio managers was that they didn't have any idea how to decide what to buy or sell, they had jobs, they didn't have a lot of time to research a stock so Technical Analysis with some of the more simplistic concepts such as moving average crossovers as buy/sell signals became a very attractive answer to the problem and the books pushing these ideas cherry picked examples to make it look infallible. MOST WHO TURNED TO TECHNICAL ANALYSIS DID SO OUT OF PURE LAZINESS!

CEMENTING TECHNICAL ANALYSIS AS A LEGITIMATE WAY TO MAKE MONEY

With all of these new books popping up, each with some new indicator or trading system, it became very important for these authors to prove their system worked, that Technical Analysis worked, so if you read enough of these books or went to enough weekend seminars, you were slowly, but steadily indoctrinated with the idea that if an indicator or trading approach did NOT work in a trade, it was because YOU did not use it correctly, YOU did not show sufficient discipline to the principles of Technical Analysis; this would later have huge repercussions.

Technical Traders were brainwashed in to believing they must follow Technical Analysis almost like a cult and if their trade failed it was because their discipline toward the concepts of Technical Analysis faltered so what you ended up with was a group of traders who all did the same thing, all saw the market the same way and none questioned Technical Analysis, in fact to this day even as Technical Analysis is used against traders EVERY SINGLE DAY, they STILL haven't changed, learned or modified their techniques, they just search for a better indicator, the newest and latest "Holy Grail of Trading" and it just doesn't exist! What may work for one stock in one type of market for one type of trader may be a total failure with another stock or in another market atmosphere.

However, this all cemented the legitimacy of Technical Analysis in place as well as the idea that if T.A didn't work for you, it was something you did rather than a flaw in the concept or a changing environment.

Watching Technical Analysis Lose It's Value

I must say, for a while, the VIX below 20 or above 35-40 was a useful reversal signal. Price patterns worked, it seemed Technical Analysis could deliver what it promised, but slowly trade after trade would go wrong, things didn't work out or look the same way they did in the textbooks. Soon it became difficult to feel a high degree of confidence in Technical Analysis, your favorite price patterns that worked so many times before were now less reliable and some of your favorite indicators became less reliable. Some spoke out and did studies and showed how Technical Analysis was either a 50/50 proposition or that it was very effective 20 years earlier, but had lost its edge over recent years. After devoting so much time to understanding Technical Analysis, using it, promoting it, it was difficult to look at these critiques and take them seriously. After all, if Technical Analysis was losing it's effectiveness and Fundamental Analysis was nearly useless, what in fact was left? Out of that dim view, it became easy and almost essential to dismiss any critiques of the effectiveness of T.A.

*I don't mean to say that Technical Analysis is useless, there are still many elements that work especially over a long time horizon, but there's not doubt that it was no where near as useful as it use to be.

YOU CAN'T ARGUE WITH YOUR OWN LYING EYES...

I taught Technical Analysis for nearly 4 years at our county school system's adult education program, it was one of the most popular classes of some 60 or 70 classes and we almost always had to turn people away for lack of a big enough classroom. People were starving for a way to manage their own money, to find out what they were doing wrong, why the concepts in the books weren't working for them. It became harder and harder to justify and sing the praises of T.A. so instead I started showing students ways they could use conventional indicators and techniques in unconventional ways, to effectively "See what the crowd was missing", to modify or modulate the ideas.

However after years of trading exclusively for a living and even more years do nothing but watching the market all day, every day, something became clear to me. There was a repetitive pattern that occurred over and over again, it was Technical Analysis in the short term (the area where institutional money could afford to manipulate the market)  that these failings were most obvious.

After some thought about the history I had lived through with Technical Analysis, the markets and the perception towards Technical Analysis I had noticed, mainly that it was nearly infallible unless your faith or discipline failed you, that it became obvious to me. I realized I could write a book and justify any technical concept I wanted, there are so many stocks, so many time frames and so much history that I could justify any view I wanted with all of this information and all of these scenarios, if I was predisposed in to believing in that view, but was that objective or subjective? The tricky thing about the market is it will give you enough ambiguous information that you can make and back up any view point you want if you look at the information that supports your view and disregard the rest as being some sort of anomaly.  

If an assessment of Technical Analysis was subjective, what was the purpose? You're hopefully in the market to make money, not to justify a way of doing things that you have grown to know intimately, a technique in which you have spent years trying to perfect,  but perhaps is no longer as effective; so it took a very objective view that was oriented to succeeding in the market. It took the willingness to say, "Everything I've learned up until now-thousands of hours of study, MAY NOT BE AS EFFECTIVE AS IT ONCE WAS" and then to ask the question, "What is my purpose in the market, to try to keep doing things the way I had always known and understood like the back of my hand or to maybe step in to a new world that challenges all of my prior views and one in which there is no road map?" The answer to these questions really comes back to that basic market maxim, "Do you want to make money or do you want to be right?"; sometimes the two are VERY different things.

HOW TECHNICAL ANALYSIS BECAME A GIFT TO WALL STREET

By the year 2000 with so many discount online brokers and charting software, the Broker-based Wall Street business model that had been alive for decades was suddenly fading away in to obscurity. College graduates weren't going for their series 7  and other licenses to become a broker, who were people who knew little more about the market than any of us, but had a license to sell (or buy) and collect monster commissions from you, discount brokers too that away.

It didn't take Wall Street very long to understand mainstream Technical Analysis, after all, the big money on Wall Street had been using the most advanced forms of Technical Analysis for decades on monster computing systems that none of us could afford or fit into our home office. It didn't take Wall Street long to realize that when presented with a specific price pattern or indicator signal, that all traders would react the same way. Because Technical Analysis in its attempts to stay relevant to sell more books and seminars had conditioned traders to believe that if the technique failed it was because they didn't stick to the technique, it was the trader's fault for not showing enough faith in Technical Analysis. In a strange way, the proponents of Technical Analysis made the way traders looked at charts so uniform, so predictable that it became very easy for Wall Street to now use those views against these traders.

What was once a system for finding the footprints of smart money in the sand and following them had now been totally turned against Technical traders and their belief and convictions in the validity of T.A. just made it and still make it that much easier for Wall Street to use Technical Analysis against Technical Traders...

In the next section we will look at examples of how Technical Analysis is used against traders, how to spot it, how to validate it and how to use it to your advantage.