Does Technical Analysis Work?
I have been delaying writing this article for some time now, simply because of the number of sub-arguments that arise when one tries to answer whether technical analysis works.
I am going to try to keep my arguments as simple and pertinent as possible. This article is primarily aimed at:
— Those who have heard the term technical analysis but do not know what it entails
— Those who are well aware of the practice but remain sceptical
It is at this point I should stress that by no means am I rehashing some orthodox doctrine on what technical analysis is and isn’t (if there were such a thing). These are my personal views and a way of thinking about technical analysis that has made me a better trader.
Moreover, just to make my position clear: I am primarily a technical trader, therefore my implicit position is that technical analysis ‘works’ (to be defined later).
Section 1 — What is Technical Analysis?
Section 2 — What Must It Do to ‘Work’?
Section 3 — Is All Technical Analysis Equal?
Section 4— Complementary Not Contradictory
Section 5— Conclusion
SECTION 1 — WHAT IS TECHNICAL ANALYSIS?
When trying to define technical analysis, it is almost easier to do so via negativa (describing what it isn’t) as opposed to giving a positive definition.
I define it thus: technical analysis is the practice of analysing the price history of an instrument in order to make actionable, risk-defined forecasts of its future price.
This is a fairly humble definition of technical analysis. The confusion and disagreement about the definition is also understandable given it’s not uncommon for definitions to focus only on the price forecast element.
For example, Wikipedia defines technical analysis as “an analysis methodology for forecasting the direction of prices through the study of past market data…”
While this is correct on its face, I would posit that the “actionable, risk-defined” qualifiers are important.
The argument is quite simple: seldom is a price forecast in itself enough to warrant a good, technicals-based trade. It’s not enough to simply state whether one is bullish/bearish and end the analysis there, for it would suggest that one ought to just take a directional trade in that direction and see what happens.
Instead, most traders will also outline a target (where they wish to take profit or close their trade) and a stop loss (where they wish to exit the losing position to prevent further losses).
Thus, by adding additional parameters (basic ones being the target and stop), a mere price forecast turns into an actionable, risk-defined trade.
So given this premise, what is technical analysis?
I would argue:
— Technical analysis IS NOT analysing price history to gain knowledge of the future price of an instrument
— Technical analysis IS a risk management tool that can be used to derive probabilistic, actionable, and risk-defined trade setups on an instrument
Putting all these principles together, I believe the utility of technical analysis is best summarised as follows: technical analysis is a probabilistic risk management tool that can i) generate new trade ideas ii) convert price forecasts into actionable trades.
If there is one element of my definition(s) that ought not to be contentious it is the premise that technical analysis is probabilistic, not an exact science.
Technical traders, irrespective of whether they are discretionary traders or using some sort of automated strategy, are looking for better odds and for their setups to render them profitable over enough trades.
Technical analysis is not a method to logically deduce the future price of an instrument.
SECTION 2: WHAT MUST IT DO TO WORK?
When answering whether technical analysis works, of course one must establish what ‘works’ means.
I believe this is the source of much confusion.
Many articles berating technical analysis compare the average retail trader to the traders working at professional firms and desks, to high frequency trading firms, and so on and so forth.
The argument runs something along the following lines: retail traders’ competition consists of firms with better tech, better spreads, smarter people, faster execution, and so forth — it is therefore inherently unlikely that Steve punting trades from his laptop at home has much of a chance to make money.
I believe that setting up a comparison between a retail trader and a specialist firm/desk is futile (and arguably duplicitous).
It assumes that in order for the retail trader to make money, s/he needs to somehow outperform the professionals. That assumption is implicit in the comparison, and it is misguided.
Simply: all the retail trader has to focus on is his/her own trading and profitability. It doesn’t really matter how the ‘competition’ is doing relative to you as long as you’re meeting whatever reasonable goals you’ve outlined.
Now to answer the question: how does one ascertain whether technical analysis works?
Well, let’s revisit our definition and assess whether technical analysis succeeds in achieving those ends.
Technical analysis is the practice of analysing the price history of an instrument in order to make actionable, risk-defined forecasts of its future price.
This is a reasonably straightforward set of criteria to satisfy.
We are NOT asking whether technical analysis can predict the future. We are also NOT asking whether technical analysis means retail traders can bodybag professional trading firms.
The test is much simpler: can technical analysis generate risk-defined trade setups?
In my mind, the answer is ‘yes’.
When technicians are mapping out their levels/waves/indicators — whatever myriad of tools they use — the aim is essentially the same: identify and execute a trade setup offering asymmetric Risk:Reward.
Two further arguments come to mind (that I can only outline, this is already too long):
- There are plenty of professional traders (individuals who get paid to trade other people’s money) who use technicals in their trading one way or another. I say this in order not to create a false dilemma wherein the guys and girls at home are using technical analysis, and all professionals have an automated strategy doing all of the heavy lifting. That is not the case.
- Automated strategies are not devoid of technical analysis, even at the professional level. While the machine will execute flawlessly and without any remorse the strategy that it is programmed to execute, it still requires inputs. For example, if my theoretical fund trades an automated trend-following strategy, I still need to define what the trend is and stipulate the conditions under which to get long. Machines don’t ‘self-execute’ — they execute the strategy that they are programmed to execute, and that programming often includes technical analysis-based parameters e.g. moving averages.
I’d like to conclude thus: technical analysis ‘works’ because the requirements it has to meet for that to be true are not unreasonably high. It doesn’t have to predict the future, nor must it outperform better-equipped professionals. As long as it helps traders identify and trade asymmetric risk:reward trade setups, then it works.
SECTION 3: IS ALL TECHNICAL ANALYSIS EQUAL?
However, I’d like to make a critical distinction:
— I am arguing that a trader who is more systematic and selective with his/her own trading is more likely to be successful than a trader that is not
— I am not (for the purposes of this article) arguing that some systems and strategies are better than others
What do I mean when I say not all technical analysis is equal?
There’s a difference between a trader with discipline, patience, and a set of trading rules and setups that give a statistically positive expectancy versus one who throws up a chart on any time frame and looks to punt anything that looks like a bullish pattern off BabyPips.
This is an important distinction because many criticisms of technical analysis are predicated on crazy, caricatured laser tag charts and directional gamblers rather than good technical traders with a statistical edge.
This premise relates to the broader question in the following way: when one asks whether technical analysis works, it is all too easy to use the lowest common denominator and pick the extremes; people who are essentially gambling. Technical analysis is much more likely to work if you do it properly and take it seriously — like most good technical traders do!
Thus, when positing that technical analysis does not work, the more compelling case will be the one that can explain away the decades of successful (retail and professional) technical traders as opposed to knocking down a straw man at the expense of an amateur.
The tool is as good as its user. It’s not uncommon to see two traders have the same levels/structures marked out on their charts. Actually trading them and managing risk, however, are different beasts entirely.
Is it really fair to blame technical trading as a whole if an individual lacks the discipline to apply it properly?
I humbly submit that the answer to that is ‘no’.
SECTION 4: COMPLEMENTARY NOT CONTRADICTORY
The debate is often portrayed as technical analysis ‘versus’ fundamental analysis, which is an unfortunate (and unnecessary) dichotomy.
This is often rooted in the fact that many technicals-only traders (especially in cryptocurrency markets) see fundamentals as secondary/unnecessary/already priced in/a meme, whereas fundamentals-only traders will find it absurd that their research is ‘unnecessary’ and ‘all you need is the chart, bro’.
As the subheading suggests, a good investment strategy (in my opinion) is likely to employ both, where appropriate.
For example, let’s suppose your fundamental research on an instrument suggests that it is likely to appreciate in the short to medium term. That’s a forecast based on fundamental analysis. Subsequently, using technical analysis, you can look for an actionable, risk-defined trade setup in line with your bullish forecast.
Conversely, you might create a watch list of instruments based on fundamental research (e.g. cryptocurrencies that have yet to exit scam) and then look for technical entries on those assets depending on the direction of your theses.
The point is this: one must not necessarily pick one or the either, nor do I think they necessarily have to compete/crowd the other one out.
Play to your strengths, and at least be vaguely aware of the ‘other side’ to give you a more thorough image of the market you are trading.
SECTION 5: CONCLUSION
What better way to end than with a list?
— Technical analysis is a risk management tool that can be used to derive probabilistic, actionable, and risk-defined trading setups on an instrument
— Technical analysis is not about knowing/deducing the future price of an instrument
— The point of technical analysis isn’t to outperform professional desks and firms, it’s about whether it can help a trader carve out an edge and a positive expectancy in the market(s) they trade
— Not all technical analysis is equal — it’s much more likely to work for someone who takes it seriously (disciplined, systematic, etc.) than someone who just takes a punt
— Don’t get sucked into the technicals vs fundamentals argument — focus on whichever works best for you and have at least an elementary grasp of the other
There’re plenty of exciting topics that I haven’t covered (why/how technical levels and tools are respected by the market, what moves price, and so on) but we’ll save those for another article.
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