Technical Analysis Fails: The Pitfalls of False Signals

Technical analysis is an absolutely essential practice for anyone who wants to carry out a trading activity worthy of this name, based on rationality rather than improvisation. However, this does not mean that technical analysis is infallible and always guarantees a result. This is true even in the case - not at all obvious - that it is carried out "properly". The truth, however disheartening, is the following: even the best technical analysis is fallacious. The issue revolves around the concept of false signals. Phenomena that unfortunately often recur in a trader's life regardless of their level of experience. We discuss this in this article, offering an overview of the phenomenon, describing the damage it can cause to investors, and providing some advice on how to best deal with it.

Technical analysis, signals, false signals: an inevitable triptych

To understand what is really meant by false signals, it is necessary to know the meaning of "bare and raw" signals. Signals, quite simply, are the evidence that the trader collects during technical analysis. Evidence that by definition has a strategic value, suggesting how to compose the trade, the correct entry point as well as the correct exit point, and the direction the asset is about to take. At this point, it is very simple to understand what is meant by a false signal. A false signal is simply a signal that provides evidence that does not correspond to reality. It is equally easy to understand how a false signal can harm the trader. Since signals are used to design a trade, if the signals are wrong, the trade will inevitably be a failure, unless there is an improbable stroke of luck. The bad news is that false signals represent a physiological component of the trader's activity, regardless of the quality of the technical analysis and the experience of the trader himself. Obviously, it is possible to reduce the effects of false signals or recognize and avoid them, but as for the bare and raw phenomenon... That is really complicated, if not impossible, to eradicate. The reason is a bit counterintuitive. The market is built on some internal rules, rules that generally hold always or almost always, but which are susceptible to being disproved, and not even that hardly. The truth is that the market is influenced by an extraordinarily high number of actors, retail investors, institutional investors, etc. This variety of protagonists and actions gives the market a tendency towards chaos, a risk of unpredictability that jeopardizes the effectiveness of technical analysis. It actually works "in the best-case scenario", that is, when the market respects its own laws. All this is assuming that the technical analysis is carried out correctly, another eventuality that is far from obvious. Regardless of its intrinsic and extrinsic effectiveness, technical analysis remains a complicated activity that requires knowledge, skills, and experience to be practiced at its best. In light of all this, it is not surprising that false signals are the order of the day. Fortunately, although it is impossible to eradicate the phenomenon - it is good to repeat it - it is still possible to contain it, to drastically reduce its effects, to incorporate the inevitable damage within a trading system and Money Management. How to do it? In the next paragraph, we offer some advice in this regard.

How to survive false signals

Surviving false signals is possible. It is feasible to take actions that reduce the impact of false signals on one's trading activity. In general, this can happen in two ways: recognizing a false signal in time and avoiding it, simply ignoring it, or ensuring that the damage caused by it is as minimal as possible. Below are three tips that are all in all simple to follow to achieve these goals.

Focus on risk management

Risk management refers to the whole series of actions aimed at containing risk, in its severity and effects. Practicing good Risk Management means calculating with high precision the risk one is exposed to trade after trade, and modulating the exposure based on the latter. Risk Management, however, also means putting in place "alarm systems" that impose an almost automatic exit from the market in the event that trades turn presumably irreversibly into a loss. The reference is precisely to the stop loss. What does the stop loss have to do with false signals? Well, it has a lot to do with it. For example, it is possible to incorporate the possibility of relying on a false signal (a far from theoretical possibility) into one's Risk Management system, precisely through stop losses. We are referring to the opportunity to set a very tight stop loss very close to the price, in order to minimize the loss caused by a possible false signal. This technique, which is clearly conservative, nevertheless has its disadvantages. The biggest one consists in the risk of exiting the market even when a trade is in a loss, but not irreversibly. If the stop loss is very close to the price, it can happen that one exits the market even when the trade could actually turn positive again.

Focus on the long term

The long term is a resource to deploy in many situations, to solve a multitude of problems. In the long run, everything is diluted, even catastrophes, even immense losses generated by Panic selling. Therefore, the long term can be helpful in neutralizing the effects of false signals as well. The reason is intuitive: if one operates in the long term, if fewer trades are made, there is a lot of time available to take care of it and therefore also to recognize that the signal just collected is actually a false signal. In short, choosing a long-term approach means increasing the attention threshold and the ability to spot false signals before it's too late. Again, some disadvantages are noted. The most obvious one is the impossibility of taking advantage of short-term trading opportunities, fast trading rather than intraday trading. This disadvantage is particularly inconvenient especially if the trader is actually accustomed to shorter time horizons.

Increase the volume of analysis

This is the most practiced advice, the most used approach to deal with false signals. Quite simply, it consists of increasing the analytical effort, implementing one's technical analysis activity with further precautions and even more massive tools. In practice, increasing the volume of analysis means using multiple indicators simultaneously. Some traders always use at least two, others abound. Still others, even four indicators at the same time. What is the point of using all these indicators to study the same object or the same market phase? Well, there is a point, and it is even obvious: it is a matter of setting up a system of proofs and counter-proofs that allows spotting false signals. If a signal, as strong as it may appear, arises from the use of one indicator but is contradicted by a second or third indicator, then it is likely that signal is actually a false signal. Unfortunately, this approach is not all roses either. Some disadvantages are noted in this case as well. The biggest disadvantage consists in the loss of time, not intended as wasted time but simply as the need to devote more space to the analysis activity, which therefore takes up a good part of the trader's day and mental resources. It must be said then that not all indicators are easy to use; some could represent an additional risk. Using an indicator "badly" is equivalent to exposing oneself to the risk of - again - running into false signals.