The other day my colleagues and I debated the merits of technical analysis.
The reason why we had this debate in the first place is that in crypto there is an unhealthy amount of recommendations based on technical analysis which will undoubtedly bring financial disasters to novice traders.
Our problem isn’t with technical analysis itself. It’s the fact that:
- 99% of people who make or follow these recommendations aren’t aware that any individual trading signal, be it technical or fundamental, brings very little edge. You would be a god if you could win 55% of the time and lose 45% of the time. Yet people make predictions as if they are bound to happen.
- Prediction is only half of the trading system. The other half is how big should your order (and by extension position) be? You would be surprised by how much P&L difference this makes. Like Nicholas Taleb would say: “don’t tell me what you think. Just tell me what is in your portfolio”.
In my mind, there is no doubt that technical analysis can work. Been there done that. All technical analysis is, is prediction based on price and volume. Ignore the proponents of the weak-form Efficient Market Hypothesis.
But that’t not the most interesting point of this blog post. The most interesting point is the relationship between technical analysis and Amara’s law.
We tend to overestimate the effect of a technology in the short run and underestimate the effect in the long run. — Roy Amara
There are so many historical examples of this, such as railroads and internet. And maybe blockchain. But what the hell does Amara’s law have to do with technical analysis?
All technical patterns essentially boil down to either trends and reversion. No shit. The market will either keep going in the same direction or revert in the opposite direction. But there is a important pattern, well-known within the quantitative trading industry, which have consistently behaved across pretty much all the asset classes that have ever existed, and I have personally backtested it for the asset classes of equities and cryptocurrencies:
Market prices tend to revert in the short run and to trend in the long run.
In other words, if price recently rose, it is more likely to fall in the short run and to rise even more in the long run. That’s suspiciously similar to what Amara said, that technology tends to be overhyped in the short run and undervalued in the long run.
Maybe we are onto something fundamental about mass psychology. Over the years I have come across several behavioral theories that could help us understand this short-run over-reaction and long-run under-reaction. Just as an example, here’s Prospect Theory’s attempt to explain why markets under-react in the long run:
If a position has risen in value we are happy to take profits and sell quickly […]. The main motivation behind selling positions at a small profit appears to be to minimize regret. If the stock fell back after reaching a new high we would castigate ourselves for not taking profits earlier. Selling also confirms that our initial buy decision was correct. We hunger to get that confirmation as quickly as possible.
Robert, Carver. Systematic Trading: A unique new method for designing trading and investing systems (Kindle Locations 472–478). Harriman House. Kindle Edition.
I won’t pretend to understand clearly why the masses over-react in the short run and under-react in the long run. But I do remember that sometime in 2011 when I first learned about Bitcoin in a Bloomberg article, I said to myself: “Man, it’s too late, it just rose 10x to $11 and the mainstream media are talking about it.” A few weeks later Bitcoin did crash, and I thought I dodged a bullet. And the rest is history.