Does Technical Analysis Work?

To some degree, academics are the only ones who have the right to ridicule technical analysis, at least in my point of view. That statement is directed to people who can’t even put up a concise valuation model of a particular company and yet criticize investors who use technical analysis. Surprisingly, some people do that, and my retort, “just because you don’t understand it, it doesn’t mean it’s wrong.”

The study of historical prices and its patterns have been a subject of constant mockery in the past, but it evolved into a more formalized field of study with institutions like the CMT Association and International Federation of Technical Analysts (IFTA) awarding designations for students who have passed all exam levels. Behavioral finance, a subject integrated into academic studies, is also closely related to the study of price patterns. But, despite all these, TA hasn’t been given the respect it deserves, and the lingering question persists: does technical analysis work?

Keeping it real

So before you read on, let me tell you about what this article isn’t. This isn’t a promotion for traders to grow in love with technical analysis and start trading in huge volumes. Sure, that sounds appealing in a revenue-generating point of view for a company, but that’s not how we do things at Intellinvestors, we want to help readers out by providing valuable information. So, in this article, I will remain on point in delivering a succinct digest of technical analysis.

Let’s begin.

A little history

Even with the financial information of a company available, I could never tell if its stock has been trending upward by just looking crudely at its stock price. I can pull out all the texas instruments in the world and still won’t determine if a stock has been on a tear lately. There’s no way for me to decipher how the market is treating a company’s share if I don’t keep a record of past prices. On the other hand, with the financial information, I can estimate if the company’s stock price is justified by its earnings or not; I can tell if we are over or underpaying for a company’s share based on its financial figures.

In a world before Benjamin Graham’s Security Analysis, tracking the prices of financial assets, commodities and especially stocks to predict future movements reigned supreme. Whether it’s Sokyo Honma (the Japanese rice trader credited for the candlestick chart) or the Dutch merchants of the 17th century, traders of old delineated price patterns on hand-drawn graphs and made inferences concerning the market’s behavior on the commodity or asset they were trading. Price levels served as reference points that somehow the market may vacillate to and fro.

It was only after Charles Dow started publishing indexes of the railroad and industrial companies in the 19th century to predict the economy when technical analysis became more of a religion for figuring out the financial markets.

Why technical analysis is criticized

Charles Dow published only the stock price averages of the companies that were tabulated in his index, but it laid the cornerstone for a more advanced study of technical analysis. Thenceforward, complex calculations were formulated for developing newfangled indicators — ones that could leave those without a math major at sea.

A common criticism for TA is that it is all just about drawing lines and shapes which can be prone to biases that overturns the possibility of putting together an objective analysis. I can attest to this. One time a trader in my ex-company brought up a chart that resembled a meatball pasta, but his main point was that the EUR/USD will most likely be rallying that day. Even though I understood his work of art (sort of), his conclusion that the Euro will finish stronger than the dollar is derived from an amalgam of complicated metrics that he hadn’t dared calculate himself — it was just based on what those indicators were believed to indicate. Not that knowing how to assemble an iPhone is a prerequisite to understanding how to use it, but in the world of technical analysis, an appreciation for its math helps in making sense of the calculation’s whys and whats. With a broader grasp of what is being calculated and why it is calculated in the first place, a trader can construct a congruous combination of indicators and oscillators, not just shapes and lines. Or, a trader can also scrap all of it if it doesn’t make sense to him and move on to what does.

The continual invention of new indicators is another flak for TA which suggests that all previous ones have either failed or lacked a good success rate. However, this fault could be attributed to the geniuses who keep on digging for the holy grail that is prognosticated to reap the profits all across the financial markets. And, the traders who patronize these breakthrough indicators with hopes of solving all their trading dilemmas aren’t irreproachable either. I think the problem lies not in the indicator, but in the psyche of the trader. Unless that trader addressed his emotional state when trading, he will not be able to make any indicator work for him.

Studies on TA

I’d take an old paper by professors William Brock, Josef Lakonishok and Blake LeBaron in 1992 as evidence for the efficacy of technical analysis. Their research tested two strategies on the Dow Jones Index from 1897 to 1986 which involved a long and short period moving average, and the other one is support and resistance trading. Both strategies, with a standard set of rules, had proven to support the notion that past prices may have the ability to predict future movements.

The technical trading setup

For the most manageable technical trading setup, I will lean toward the support and resistance strategy of Baron et al. The simple buying at support and selling at resistance (although in the 1992 research buying signals were more profitable than the sell signals) and watching out for potential breaks in those levels present a straightforward strategy in using past prices. The approach doesn’t convolute the charts by adding numerous indicators, but it offers a clear interpretation for where prices are assumed to go.

Keeping it simple

Professor Blake Lebaron followed up the 1992 research with his “The Stability of Moving Average Technical Trading Rules on the Dow Jones Index” in 1999 and in that paper, he suggested keeping trading rules simple. Overcrowding a chart with lines, drawings and a combination of the different versions of moving average may send off mixed signals thereby precluding a trader’s profitability.

Does TA work?

Using technical analysis to trade the financial markets can be just as lucrative for a trader as fundamental analysis. One could choose to be a chartist, and one could opt to be more of a fundamentalist, but both approaches work. In technical analysis, it’s crucial for a trader to remember that simplicity is the key and perhaps even with FA.

I end this article with a quote from Martin J. Pring’s Investment Psychology Explained, “It makes no difference what a trader or investor takes or, for that matter, what method of analysis he chooses. The most important tool required by anyone approaching the markets is a methodology on which to base rational judgments.”

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