Does Technical Analysis still work?
Written By Alex Ferracuti
What is Technical Analysis?
Technical analysis also known as charting, is used to price securities and attempt to forecast future price movements. This process usually uses price charts, trends, trading activity, and statistical methods to determine the direction of a stock. To differentiate between the two major methods, fundamental analysts seek to find the “intrinsic” or underlying value of a company, while technicians (technical analysts) use price charts and other tools to evaluate the strength of a stock’s price. Technicians believe that past trading activity and price changes are better indicators of a company’s value than intrinsic value. Technical analysis was created under the assumption of the Dow Theory, which says two major things: 1) Stock prices contain all available information discounted, and 2) Market movements are not random but move in predictable patterns. Generally, is it based on the basics of supply & demand of the markets, where its primary aim is to analyze market sentiment and behavior rather than the value of a company.
Quick Rundown of Market Efficiency
Academics and investors have studied the true efficiency of capital markets for a long time now. The concept has been named the “efficient market hypothesis,” EMH for short, which contains three postulates: weak-form, semi-Strong, and strong-form. We will discuss the latter two as they pertain more to technical analysis. Starting with the semi-strong form, it is the most widely believed of the three proposed. It assumed that markets are efficient, and that stock prices incorporate all publicly available information (historical and current). Strong-form EMH believes a similar policy, where stock markets reflect all information both public and private – so that no investor would be able to profit from any other given new information. Both forms of EMH believe that markets adjust very quickly once the information is made available or generated. These concepts are especially important, because the basis of the Dow Theory (and technical analysis) is based on the strong-form of EMH. The concept that markets discount all available information, leads technicians to believe that no investor can profit above any others from the use of finding the intrinsic value. Therefore, technicians look to find patterns and other tools to find the benefits in this system.
Proponents for Technical Analysis
Current technicians believe that technical analysis methods still work to this day, the same as when they were created. There also seems to be a large number of day-traders who still support and use technical analysis in their trades. Proponents comment that it is less about determining the value of a stock, but to find the general trend (bear vs. bull) – from which you can profit from. Investing short-term is about reading the attitudes and behaviors of market participants. It is also believed, that markets aren’t as efficient as people think, and that trends and patterns always seem to repeat themselves. Many people, who still use technical analysis, say that people should not rely solely on it, but rather as an ending point to their fundamental analysis. It helps with finding entry points into a trade and the confirmation of fundamental analysis.
Technical Analysis Skeptics
Skeptics believe that techniques used in technical analysis may have worked in the 60s and 70s when they were created, but no longer have value in today’s markets. They believe that technicians have a strong form of confirmation bias, to “believe” and confirm that the patterns and tools they created worked. Technical analysts had simply fallen for the concept of correlation not equaling causation. Another factor that skeptics bring up is that personal computers were not around when technical analysis worked reliably. People had to visually look at charts and calculate metrics – making this process tedious and timely. Algorithmic trading, which was introduced with the personal computer, would have removed any of these clear methods of profiting. Computers and programs could cut down the time to find these opportunities to near instant, which as a result would make any market anomalies that allow arbitrage to disappear. Lastly, critics say that technical analysis is more a “get rich quick” scheme, than actual analysis. They believe that people are profiting off the losses of others. If markets were that easy to read and predict, by applying a few indicators, everyone would be doing that in the market.
In conclusion, whether you be an advocate or critic of technical analysis, it be beneficial to learn about its applications and methods to come to your own conclusion. Most believe that using technical alone is not very strong – but using in tandem with strong fundamentals, could lead to more powerful analysis.