Does technical analysis actually work?

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Many traders have claimed to use technical analysis to guide their forecasts and hence make money on the financial markets using this method of analysis, however in this article I will actually argue my case against it. But firstly, what does it actually mean?

Technical analysis essentially entails the use of past price information to predict future price movements. For example, a basic (albeit crude) way to use technical analysis would be to say that if Stock A has currently established a support level of $25 a share over a period of, say, a few months, and today it reaches that level again, but breaks it, dropping to $24.50 a share, then that is a bearish signal on Stock A in the near term future. To me, the first problem with this is that you ONLY use price to inform your trading decisions.

The theory of value investing can give us a valuable lesson to relate to this point – human beings are irrational and hence the market does not always accurately value different companies. For example, during the euphoria associated with the early stages of the dot-com bubble Pets.com shares rose to a high of $14, with the company becoming defunct not even one year later. Such behaviour is indicative of the fact that share price does not always tell the full story of a company’s basic fundamentals, and simply trading on technical indicators is to rely on human emotion rather than solid fundamentals, which is a recipe for potential losses. This illustrates the first deficiency of technical analysis: the fact that the share price of a company is not the sole indicator of its business fundamentals.

However, a counterargument to this point would be that it is indeed possible to use technical and fundamental analysis in tandem to achieve profitable results. While this may be true, it’s interesting to question how much of this profitability is down to the technical analysis itself, and how much is down to just luck. Technical analysis is fraught with ambiguity; different methods of technical analysis have been seen to be contradictory to each other and, moreso, applying different methods of analysis to different financial instruments can possibly yield the same result. There is little room for nuance or financial instrument-specific related analysis actually related to the company or currency pair (for example) itself. This is surmised well in a quote from Warren Buffett, where he says “I realised technical analysis didn’t work when I turned the charts upside down and didn’t get a different answer.”¬†Much of technical analysis is also based on human psychology, which renders it increasingly invalid given the increasing prevalence of algorithm-based trading strategies in the financial markets.

Moreso, arguably for technical analysis to work in analysing different financial instruments an implicit assumption is that traders and investors have perfect information about the underlying instrument being traded. To falsify this, let’s use a case study:

Volkswagen AW

On the 21st of September, 2015, the first trading day after which the Environmental Protection Agency (EPA)’s Notice of Violation to Volkswagen (VW) was made public, the share price of Volkswagen AG fell by 20% on the Frankfurt Stock Exchange. Hence, all forecasts of this share price before the EPA’s announcement based on technical analysis were either completely wrong, or simply correct due to pure chance. While, indeed, fundamental analysis would have also been unable to predict this happening, the 24.7% decline in sales of Volkswagen vehicles in the US in November 2015 from November 2014 at least provides a fundamental indicator of a potential impact on VW’s bottom line, which share price (although it may have done in this case) is not at all guaranteed to do, as there may be other, external influences on the share price that cloud the impact of this scandal.

To conclude, in my opinion technical analysis is a flawed method of analysis of financial market instruments for three main reasons, the first of which is that price does not always reflect all information freely available. In addition to this, the fact that the analysis leaves little room for financial instrument-specific related nuance and also that there may be other information which is not freely available and thus not reflected in, for example, share prices, discredits the notion of technical analysis as a feasible method of analysing the financial markets. Although many traders claim to have successfully traded the financial markets using technical analysis, for the reasons mentioned above I personally do not find technical indicators worth the time compared to fundamental indicators.

Sorry for not writing for so long – public exams really took my time away!

One Comment Add yours

  1. The framing of your question is part of the problem. The correct question to pose is’ does technical analysis contain any useful information?’. The answer, oddly enough and contrary to the EMH, is yes. The term technical analysis is also very broad. You seem to mean chart analysis and even this is a wide area. There are a class of traders that only use technical analysis (the CTA for example) and they seem to do quite well as a group. However, less specialised eclectic traders, like myself, manage to extract useful information from charts and other technicals.

    If you want to characterise the information contained then ‘condition of the market’ might be useful. Charts can offer some insight into how markets are primed to move, given a suitable stimulus. If the conditions reach extremes then it does not take much of a stimulus. For example, RSI divergence can, at times, be a powerful signal of condition. From your blog I get the impression you are not that knowledgeable on charts and have come to this conclusion on rather superficial analysis. Take a closer look you may be surprised.

    I came to trading from being a finance academic with specific interest in the Efficient markets Hypothesis. I was introduced to technicals by old style traders. I was naturally sceptical but kept an open mind. It paid to keep an open mind.

    Liked by 1 person

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