How Reliable Can Technical Analysis be?

6 mins read
by Angel One

Technical analysis is a trading discipline that is used to find the future value of stocks and other financial instruments in order to unearth ideal trading opportunities. It relies mostly on statistical trend analysis and relies heavily on historical records of trading activity. Technical analysis has a conflicting reputation, and the doubt around its efficacy is understandable- given its historical origin and abuse by some investment analysts. As a method that predates computing, it hasn’t been created within the modern quantitative frameworks and has antiquated names like ‘head and shoulders” or “cup with a handle” that might not inspire trust in its scientific merit. But despite all the doubts surrounding it, technical analysis has been hard to do away with and remains the dominant mode of analysis in some financial sectors.

Primary characteristics of technical analysis explained

> It is a financial trade discipline and it is used to find and vet trading opportunities using statistical trends and patterns on historical data.

> It relies on the historical analysis of trade activity and price-shift to predict future changes and therefore is largely pattern-seeking and intuitive.

> It is often seen in direct opposition to fundamental analysis – a form of prediction where the focus is more on the company’s financial potential rather than underlying patterns and trends in its stock.

> The indicators for technical analysis are price and volume studies- where its tools are used to look at the way supply and demand for a stock would affect its price and volume fluctuation. It can be useful in understanding short-term trade but also is a good gauge of the strength and weakness of equity in the market.

Technical analysis was theorised by Charles Dow in late 1800, after which it was worked on by researchers like Hamilton, Rhea, Gould and Magee to create what we know as the Dow Theory. To learn technical analysis you need to consider numerous new signals and patterns that have developed ever since. Technical analysis can be used on any financial instrument that has historical trading data available, where it is most commonly applied for predicting short-term price movements. The basic logic of technical analysis is that the past behaviour of security can indicate its future price values when combined with the correct metrics and frameworks. Therefore, technical analysis is largely used in combination with other forms of research.

The three parameters of technical analysis are

1. Equity value is inclusive of everything- in the market and in the company’s own history and fundamentals. Therefore the price of the stock subsumes other factors in the overall market, like behavioural tendencies and company growth trajectories. Thus the only aspect that needs to be analysed is the movement of prices – which is largely determined by the supply and demand rules of economics.

2. Trends are tendencies- The way equity behaves in the market, no matter how random the time period will eventually fall into a trend pattern. A stock price’s value is therefore mostly going to move within historical patterns rather than chaotically. This is the foundation oftechnical analysis.

3. Historical trends are iterative- To learn technical analysis, you have to keep in mind that this theory believes that past trajectories are blueprints for future stock behaviours. This tendency of repetition is both a subject of the predictability of human emotion and the ability to find patterns in market activity over hundreds of years.

Is it reliable then?

The efficient-market hypothesis (EMH) is one of the biggest refuters of the technical analysis method. This is because it insists that historical pricing is not a sufficient metric for understanding the future behaviour of equity markets. This is in contradiction to the belief that technical analysts that speculative stock prices are shaped by the expectations of investors, therefore past trends and patterns are logical methods to gain insights about predicting equity market trends. The debate between the fundamental and technical analysis prediction methods and those who believe in the efficient market hypothesis method is a long contention without any resolution.

A different criticism of this format is based on its philosophy about history repeating itself. The contention is that history never really repeats itself exactly, not to the exact particulars anyway- in which case the pattern can never really be repeated twice. In that case, there is no point in studying patterns that might never recur.

Finally, technical analysis is assumed to be self-destructive or self-fulfilling- where if enough people believe something is going to happen, their actions can either make that thing happen anyway or sabotage its possibility. For example, if a pattern is perceived that the stock value of X is going down; then, people will start selling their stock quickly, hoping to avoid too much of a loss, therefore reinforcing the trend that was predicted. While this strategy might seem like it is matching up the intention of predicting behaviour, it isn’t actually predicting the price in any substantial way, therefore not of any use in the long run. Moreover, in some cases, this self-fulfilling nature can also be destructive. If for instance, enough people believe that stock Y is going to increase in value tomorrow, they will end up buying a large number of Y stock today- leading to a change in the pattern that had led to the prediction in the first place.

Final Takeaway on technical analysis

Technical analysis is more an assortment of tools and theories that can be used by analysts and traders. There are traders who have been successful through it, and there are those who didn’t. It is a largely subjective experience that some might find the methods in this form of analysis is ideal for them and how they choose to form their investment strategy. While it is sure that technical analysis cannot assure a 100% success rate or magically high profits- it is however a very thorough study of how to predict equity market share value and thus can be considered a format of trade prediction.

You should ideally learn both kinds of analysis- technical and fundamental before making investment decisions because they’re actually complementary approaches. Also to learn technical analysis, one needs to study and practice the techniques accurately before committing any real-world assets, it is a skill and method like everything else and its reliability depends on the user.