There is ongoing debate over the “true worthiness” of “technical analysis” for investment strategies in foreign exchange markets and stock markets. Before we briefly define what technical analysis actually is, we should note that there are 3 categories of opinions on this matter. The “against it” crowd believes that technical analysis is the modern-day equivalent of snake oil: promising wonderful things and looking really “fancy” and advanced, but having no real value, with rigorous studies to back their claims.
The “for it” people bring forth real-world examples and good studies to defend their position, which at least partially refutes the “efficient market hypothesis” and suggests that there are excess returns to be had by practicing technical analysis.
These 2 extreme camps generally have convincing arguments, examples, and studies that “prove” their points. Finally, the third crowd has a position that things are not black and white and that either camp may be right or wrong, depending on specific markets and market conditions. Let’s discuss this interesting topic a bit further.
Technical analysis in a nutshell
Simply speaking, technical analysis is the use of patterns in graphs. For example, I may have noticed that every time the price of a specific stock or currency goes down by 10%, it always reverts to going back up and the same thing happens when the price goes up 10%: it then tends to go back down – there is “mean reversion” in the pattern. Knowing this pattern, I could simply check out the graph all day (or ask a computer to do it for me), and buy or sell after these price movements: if it went down 10% recently, buy it; if it went up 10% recently, sell it.
I could then refine this simplistic “trigger rule” by adding a trend to the price, which could be the 20-year historical trend of the asset or some aggregate market measure such as the S&P500 index. You get the idea.
It gets technical
The word “technical” is there for a reason… it can get very technical. I admit to liking this stuff, because I have a background in pure math and computer programming, and I like playing with numbers, graphs, and programming, but one needs to keep things in perspective to avoid bad decisions.
Another example would be that I define “support values” in my market: the price of the asset or index rarely goes below this “critical limit”, and if it does, all hell breaks loose; same for “resistance values”: the price of the asset or index rarely goes above this value, and if it does, it’s party time. Once these “critical limits” are busted, it may happen that new support and resistance levels are set, for example the old resistance level becomes the new support level, and so on.
I could identify fancy historical patterns: I notice that after the 3rd time the resistance value is “almost reached”, the 4th time always busts it completely, which means I simply have to watch the price relative to this resistance value (or, again, ask a computer to do it for me), and count the number of times the resistance value is hit, and after the 3rd hit, I buy once it has declined (buy low) and hold past the resistance value, because I “know” that this time, the high value is higher than before. Get it?
I could write an entire book on this subject, because it goes very far and can be very interesting, but that is not the goal of this blog post – there are many good books out there on this subject!
The ups and downs of market psychology
It seems like magic: I can be totally ignorant about markets, the economy, economics, macro policies, forex and currency fundamentals, and all the complexities of financial markets and economics, and STILL make good positive returns by becoming good and “observant” at looking at graphs! I can identify when the price is “low” based on some magical historical pattern (recent or long-dated) and buy, and do the same thing to “sell high”, allowing me to make positive gains all the time, essentially without any knowledge of economics, markets, or finance… Magic!
Some studies find that markets can indeed have “magical” elements during certain periods: certain price dynamics can build “momentum” beyond any fundamentals, making profits “easy” by riding bull markets in good times. So when times are good, they tend to continue on that path quite a while, just because everybody believes it will: I think you will keep buying, which makes me think that the upward momentum will continue, and you think the same about me, and all this creates a self-reinforcing positive feedback loop that drives prices way beyond any “logical” explanation, and this dynamic is exacerbated by low interest rates and lots of liquidity. The same logic applies on the way down, although it is not symmetrical in timing or amplitude due to complexities I don’t want to discuss here.
Some studies find that use of technical analysis by portfolio managers enhances returns relative to a standard buy and hold approach.
Other studies tell us that technical analysis drags down profits relative to other types of financial strategies, and even the great Warren Buffet feels very skeptical of its true value and usefulness for investment strategies, and an exhaustive and rigorous research done by 2 finance professors found that profits from technical analysis did not surpass transaction costs!
The reality behind some of the market fluctuation is mass psychology that defies all the good and properly-documented knowledge and research you may have acquired and done. Due to these mass psychology effects, patterns may arise and momentum aspects may indeed provide the possibility of profits in certain market conditions, and proponents of technical analysis will provide proof that it works with “good calls” made in the past using this approach.
The problem is that good calls can be made with many approaches. Bad ones too! Cherry picking good calls made with approach xyz is of no informational use. What you want is risk-adjusted NET gains (net of transaction costs, time investment costs, and other costs).
So? Does it work?
So? Who is right? Does it work, yes or no? We could go on debating the claims of both camps for hundreds of pages, and you would finish your reading still wondering: "so, what do I conclude?" Well my dear reader, the devil is in the details… sorry! There is convincing evidence in both camps, so how can we make up our mind about the usefulness of technical analysis?
Generally speaking, you are at great risk if you are applying TA on individual stock picks, because you are ignoring all the “fundamentals” of that company and sector, the potential for accounting fraud or creative accounting, and other issues related to specific-stock-picks, which could prove catastrophic with the technical analysis approach.
Again in broad terms, if you apply TA to strategies based on macro trends such as futures on stock indices or forex trends, you may indeed profit from market momentum and mass psychology effects that defy market efficiency and provide some “magic” to savvy and observant “techies” in specific market conditions and time periods.
You also have to be careful about what you are comparing against and what you are talking about in terms of returns. This is a critical aspect that puts beginners at risk of being manipulated by any camp (techies or “fundamentalists”). There are details to consider when talking about returns to a specific investment approach, 5 being particularly important:
Indeed, what is the use for individuals investing online if you have to spend all your time looking at graphs or figuring out new patterns or if you have to trade so much that transaction costs drive your net profits down to zero? Also, does a specific “pattern” repeat enough to provide systematically higher-than-average returns? Ca you constantly come up with patterns to get good returns? How much time investment does that take? How do you feel about managing your money this way, without even really understanding what is going on? When you trade in front of your screen, how does it feel to just trade on ups and downs without placing your decisions on a clear backdrop of market forces and fundamentals? Do you know that multi-billion dollar companies with powerful computers can crush your strategy within minutes, but they can't change fundamentals of markets and economies? Are you sleeping well?
Last but not least: many studies compare TA to simple “buy and hold” strategies, but that is an oversimplification of reality and compares to the wrong metric. Most people who have money in forex or stock markets will obviously have some form of “dynamic portfolio adjustments” on an ongoing basis (perhaps not daily or monthly, but perhaps quarterly or annually), even if a large part of the portfolio is fixed and based on regular dividends or coupon payments.
Some studies have found that large portfolio management firms that use TA outperform “buy and hold” approaches and firms who do not use TA. The problem here is that they fail to say that these same "TA-using" firms ALSO apply plenty of “fundamental analysis” and they “understand what is going on”…
I have yet to meet an investor who makes systematic above-average returns for prolonged periods of time without understanding what is going on in markets! Sure, you have exceptions and you can bring up examples of the guy who made 100 million by identifying a special pattern and really milking it dry, but this is the very odd case. Some get lucky, but good average returns always include one very fundamental element: understanding markets!
How historical patterns break down
Suppose I identified patterns in data that allow me to make good returns by following this “recipe.” It can be a single graphical pattern, or a more sophisticated family of correlations between various variables (that can be captured with time series analysis, for example).
To take a very simple example to make things clear, suppose I discover that every time currency X appreciates against currency Y by 10%, there is a 3% dip (due to profit taking), followed by another 10% increase and 3% dip, followed by another similar run. Then, after 3 such mini-cycles, the exchange rate stabilizes and a new pattern appears, which I know about as well. This “cycle” can happen over 5 days or 5 years, or whatever.
If I notice this pattern first and it actually really works (and it's not just luck), I can “milk” this thing dry: I know in advance what is going to happen. Imagine! So when I see that we are at the start of a cycle, I know in advance what to do and when (more or less). PARTY TIME! I borrow a zillion dollars at the money market rate, I apply my financial strategy, I end the cycle with 2 zillion dollars, I pay back the debt I owed (1 zillion), and I am left with a net zillion… awesome!
The problem is, I am not the only smart guy in the market (sorry), and others have also spotted this magical pattern. The next time comes around, and many others apply the same thing. So just when I timed my computer (or decide to do it myself) to buy based on actual time or trigger limits, it just so happens that many others timed to buy just a bit before me… they drive the price way up before I have the time to jump in (literally within seconds), and I buy at an inflated price! OUPS!
I am buying at an inflated price because others spotted the pattern too, and they bought just before me… they bought at the right "time" and I didn’t… next time others also spot the pattern and buy even before the others that messed up my profit-making strategy… OUPS again! … and eventually the whole pattern breaks down, because it has been entirely “priced in”… the magic is gone! (Sad music).
If you can identify a magical pattern that you are really sure about and will last for a few years, apply it and make a killing, especially if you can borrow large amouts of money at a low interest rate! If you think you saw a pattern and it is “high frequency”, meaning that you have to make many "small profit" transactions almost daily or monthly just to cash in on the pattern, first you are at great risk of margin losses in periods where it won’t work, second you are at risk of the pattern breaking down altogether, third, your time cost and your transaction costs are killing your true, cost-adjusted and risk-adjusted returns!
The knowledge required to understand markets is accessible for anyone who is willing to put a bit of time and energy into it, but thinking that you can get systematic returns from graphs and patterns alone is like playing the lottery or casino with your money: you can get lucky once in a while, and you may even strike it big and be able to live off your “big killing” forever, but the odds are against you and you don't even realize the risk you are exposed to, because you are clueless about what moves markets!
Using TA may be profit-increasing, but only if it is used by a person who has the human capital to truly understand what is going on in markets. This goes for forex and stock market trading. If you are into managing your own money in these markets, be sure to make the most important investment of all: the effort to learn how markets and economies work, how to actually trade successfully in forex and stocks, what drives markets, and how to follow them. This knowledge is possible to acquire for curious and motivated people, but you need to put the effort into learning the appropriate things to make the good “causal links” that drive good decisions and avoid bad ones.
If you have the time and interest to watch your computer screen all day and trade a LOT, or if you have the programming skills to tell a computer what to do and when, based on market conditions, cross-correlations, trigger limits, and more, feel free to go ahead... but all that effort could ALSO be used to actually understand markets and know what you are doing and what is actually driving markets... and that is also a source of good investment decisions (ahem!).
Concluding remarks: my 2 cents!
If there is one single thing to remember from this blog post and from all the books and articles over debates about investment strategies, here is THE thing to remember: First understand markets! Understanding what is going on is accessible to anyone, from any background, as long as you are willing to be curious and open about learning.
Whether you invest your own money or you let others manage your funds, I strongly feel that the effort required to understand markets and understand a bit more what your fund manager or personal finance advisor is saying and doing is a high-quality investment of your time and energy, and will help you feel more in control, better informed, and provide better knowledge for decisions about financial investments, not counting better sleep!
Pattern analysis, even the very advanced type, can be useful conditional on understanding what is going on in markets! This is basic common sense: there is no free lunch, and there is no magic. Yes there is luck, and there are special market conditions, but claims to the incredible superiority of one method over another are fed by cognitive bias and cherry picking more than from rigorous analysis of facts and risk-adjusted and time-and-transaction cost-adjusted returns.
If you blindly throw yourself into markets without some understanding of markets, you will be eaten alive by investors who understand what is going on. On the other hand, you would be surprized at what you can obtain for yourself and the level of understanding you can reach by investing quality time for a few weeks on quality and structured knowledge.
There is no single magic bullet, so just don’t spend thousands of dollars on things you are not sure about or seem too good to be true, and be sure to at least get your basics clear about markets!
I hope you enjoyed this post and that things are a bit clearer now! Feel free to comment, share, and to contact me. Cheers!