Criticisms of Technical Analysis

There are some who doubt the usefulness of technical analysis. After all, charts can tell us where the market has been, but why should they reveal where the market is going in the future?

Do you ever listen to the weather forecast in the morning to decide whether to take an umbrella to work? Isn’t this just the same type of situation, using what has happened in the past to try to predict the future? Certainly, weather forecasts may be wrong, just as technical analysis can be, but on the whole we consider them to be a good guide. Nothing accurately predicts the future, but it is perfectly acceptable in other fields to routinely infer by extrapolation what may happen in the future.

Fortunately, we also have evidence that the idea that you can’t make a reasonable prediction of the future from past performance isn’t true. In fact, when traders develop a system, or set of rules that they will use to tell them when to trade, they will quite often ‘back test’ them. This involves looking at what happened in the past, and seeing how the system would have performed over the years. The trader won’t even use the system unless the back test shows that it would make consistent profits over time.

Incidentally, the field of statistics actually recognizes the difference between the two types of statistics. One is called descriptive statistics, which encompasses actual historical data, such as used in drawing the stock charts. The other is inductive statistics, where predictions are made on the basis of that data.

Does Technical Analysis Really Work?

Efficient Market Hypothesis

You may have heard of something called the Efficient Market Hypothesis, which was originally proposed in the United States in the 1960s by Eugene Fama of the University of Chicago. This controversial theory suggests that it is impossible to beat the market because the existing prices already incorporate all that can be known, which means investors would not be able to find undervalued stocks. The best an investor can do is buy and hold, benefiting from future growth of the company.

Contrary to the way it is sometimes expressed, the Efficient Market Hypothesis doesn’t in fact say that the market price is right – the price may be wrong, but there is no consistent way to determine whether it is too high or too low. The idea is that the markets are random, then there’s no forecasting technique that would be successful. Of course, technical analysts totally reject this idea.

In fact there are three variations on the Efficient Market Hypothesis.

In the ‘weak’ form, future prices cannot be predicted from examining past data, and technical analysis is ineffective. All the past prices and data are considered fully reflected in the current price.

In the ‘semi-strong’ form, all information that is available to the public is assumed fully reflected in the current price, thus fundamental analysis is also useless. It’s assumed that share prices adjust immediately to any new information.

In the ‘strong’ form, all information, both public and private, is assumed to be reflected in the share prices, and no one can earn any additional returns. Even insider information is useless.

In 1973, Burton Malkiel wrote ‘A Random Walk Down Wall Street’, which espoused the idea that stock prices vary at random, and cannot be relied upon to follow a trend. Again this implies that past price movements cannot be used to predict the future direction of the stock price. This was an offshoot of the Efficient Market Hypothesis and the idea that prices fluctuate randomly around their true value. Amazingly, both these theories still have advocates, even though it is plain to traders that prices do exhibit trends and are not just random.

It’s probably true that the academicians who keep pursuing the theory haven’t ever studied technical analysis. After all, a lot of things might appear to be random if you do not take the time to learn what governs the way they work. So in this way, perhaps they are not be blamed in thinking like they do – although a little more exploration of trading theories might make them change their minds.

Some American universities have started investigating Behavioral Finance, which examines the link between human psychology and the pricing of securities. This is precisely what technical analysis is about, so one must hope that they can catch up with and validate the ideas of the trading community.

The paradox about the Efficient Market Hypothesis is that if everyone believed the market was efficient, then no-one would analyze it any more, and the market would not be efficient. Therefore, one prerequisite for an efficient market is that there are traders who do not believe in it and continue to trade to try to beat the market.

In practice, we know by the tools of technical analysis that we can form a reasonable judgment of future price movement by considering the historical data. Of course we can be wrong, but we can determine a market bias, at least. This empirical finding is all the reassurance we need to know that technical analysis is worthwhile and can lead to profitable trading. The Efficient Market Hypothesis and the Random Walk Theory are interesting sidelines, but we really don’t need to bother about them.

How Reliable are Technicals?

Here’s what one reader told us about technical analysis. “I think it is a complete waste of your time to use these strategies to trade and I see it as a pseudoscience. It is easy to spot patterns after they have emerged, but you can’t use past patterns to guess at what will happen in the future. Humans have emotions, which makes us varied and unpredictable in nature. The markets levels are set by humans who are trading on them which make them as unpredictable as we are! If the markets were perfectly predictable, then there would be no way to make money on it as the markets would reflect their true value straight away.

Don’t waste your time studying horrendously complicated trading methods or look for complex relationships on a graph, just do some good ole’ fashioned research instead and apply your knowledge with a bit of logic! However, I am not saying using charts is a waste of time. They are good for looking at the price ceilings and price floors to help work out your stop loss levels, entry and exit points, but that is it!”.

Is It Self-Fulfilling?

Another criticism that you may hear about technical analysis is that it is self-fulfilling, and has no real basis. The argument is that because traders all see the same signals, they trade so that the market moves in accordance with the overriding wisdom. Some analysts believe that charts are just for fun, BUT so many people join in the fun and believe in the charts that the fun becomes a reality in influencing the shareprice. That is why so many chartists take this seriously… When traders see what they consider to be a bullish pattern, then they all buy in the expectation of the market going up, which makes the market go up. On the other hand, if traders believe that a downtrend in price is about to start, of course they will sell the securities and everybody doing that will make the price go down.

At first sight, that sounds very convincing. No wonder the patterns work so well, if traders are forcing the markets in this way. But my first reaction to that idea is ‘So what?’ – if the trading methods work, then we have the means to trade profitably! It shouldn’t change us from using the patterns that work. That said, perhaps the idea deserves to be answered in more depth and possibly refuted.

For many years traders have studied chart patterns, and the main patterns which indicate favorable trades are certainly well known. However, to actually discern and identify any particular pattern requires some skill and interpretation, and because there can potentially be infinite variation in a stock chart there is always some question about which if any pattern is being exhibited. It is for this reason that many people assert that trading is as much an art as a science. This means that not all traders will consider the opportunity for a trade in the same way.

Consider, if everyone interpreted the market moves in a single unambiguous way, then everyone would be making a fortune. That’s plainly not the case. They say that 90% of would-be traders fail and give up in the first six months. There’s a lot more to trading, which you will be learning, than just looking for a few well-defined patterns.

Even amongst the traders who decided that the pattern was a tradable one, they would each bring their own interpretation to the opportunity. For instance, some would try to anticipate a potential reversal and trade early, while others would look for a definite move and then trade in the established direction of the trend. To some extent this would depend on the individual trader’s style, and how aggressively they chose to trade. In the end, it finishes up as unlikely that there would be any trading taking place ‘en masse’, but each would enter the market on their own terms.

As for trading being as much an art as a science, certainly there is a learning curve beyond scientific and mathematical analysis. There is a consensus of opinion that a novice trader must ‘pay their dues’ in order to become skilled. This course will cut through the time needed for that by providing you with the lessons learned from experience.

Even if there was a self fulfilling prophecy aspect to trading, any harm it did would be self-correcting. If things didn’t work out for traders when they followed their chart patterns, then they would stop using them or change their tactics. The markets are really driven by supply and demand, so traders’ actions would only distort them temporarily.

You may have heard of the ‘pump and dump’ strategy used by some opportunists. This is when someone identifies a sparsely traded stock of a small company, buys some stock, and creates a lot of publicity ‘talking up’ the company’s prospects in the near future. The flurry of activity amongst people who think the message is true can briefly change the prices, which is when the original shareholder ‘dumps’ his shares for a profit.

The shares soon fall back to their true value. This tactic works to a limited extent, but only because the selected shares had hardly any buying and selling before, so any activity made the price overreact. To think that traders, acting on their own and without a specific stimulus like this, would be able to create a market move in any major stock is probably attributing too much power to the trading community.

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