Does Technical Analysis work?

According to Wikipedia, Technical Analysis describes "forecasting the direction of prices through the study of past market data". And past market data is often presented in graphical form as charts. So why should past market data, observable to everyone, be giving hints about future prices? Is technical analysis just an esoteric exercise, similar to reading tea leaves?

Many successful traders would disagree. See this quote by Rick Santelli:

When I was an institutional broker in a former life, I was a believer in the merits of using technical analysis. I found that it was a very useful tool that complemented the much more mainstream tools generically referred to as fundamental analysis.

Still, to give the counterargument, let's start with the two main arguments why technical analysis should not work in trading.

Why Technical Analysis Should NOT Work

The first key argument is typically the Efficient Market Hypothesis. The Efficient Market Hypothesis describes that all available information about a stock or an asset is already incorporated into the current market price. Everyone who thinks the stock is worth more than the current price has bought already, everyone who thinks it's overvalued has no position or is even short. Therefore, it should be impossible to perform better than the overall market on a risk-adjusted basis. Hence, one of the best ways to invest is just to passively invest in an index and keep the fees low. The Efficient Market Hypothesis is therefore not critical of Technical Analysis alone, but also of Fundamental Analysis—if a stock would be fundamentally undervalued, would investors not have bought it?

There is some merit to the Efficient Market Hypothesis, especially since it is very hard for even finance professionals to outperform markets consistently. However, it comes with a big caveat: If everyone only invested passively, there would be no price discovery at all. Who would ensure the efficiency then?

Another big criticism against Technical Analysis is that it completely disregards Fundamentals ("Fundamental Analysis"). There have been numerous examples of market bubbles where asset prices were completely out of touch with fundamentals, e.g., the internet stock bubble in 1999/2000, the Housing Bubble, or most recently in 2020 when in February the market was completely disregarding Coronavirus hitting China and Italy, and then in June when stocks went higher and higher despite the economy being hit hard from lockdowns.

The question remains if missing out on fundamental analysis is a valid criticism. If the main goal in trading is to make money with acceptable risk, does it matter what the fundamentals say? On the contrary, wouldn't it even make sense for an investor trusting in fundamental analysis to at least keep an eye on the technical side? An undervalued stock can remain undervalued forever, and an irrational market can stay irrational longer than the investor can stay liquid.

But of course, a trader relying on technical analysis shouldn't completely leave out fundamentals. If one is trading insolvent stocks, for example, technical analysis may of course help, but one cannot fully rule out that the equity may go to zero someday (if you found some sarcasm, you may keep it). Another example is the Turkey Wellbeing chart, loosely adopted from Nassim Taleb's black swan.

Fundamentals add value to the technical trader if only to keep in mind what unexpected impact "could be expected" in a given market.

Reasons why Technical Analysis Can Work

While it's true that technical analysis only uses the past to get insights about the future, there is a lot of information stored in the observable trade and volume patterns of the past. Generally speaking, it tells technical analysts at what prices and how many shares (or other assets) changed hands. To give you a simple example, if a stock reaches a new all-time high, anybody at that point holding the asset has made money. (Well, except for that person who just bought at that price who is break even. Also, traders who are now profitable in this specific long trade may have lost money in other trades with the same asset, but that's not the point.) Anybody short is now losing money and may need to close their position at some point. So an all-time high can be an interesting signal, that is just observed from past data and can be seen in the chart.

More generally though, technical analysis helps to identify trends. Markets usually move in trends, stocks rarely just go straight up or down but are best described by a seemingly random oscillation—that generally tends to move in trends. An uptrend, for example, can typically be identified by a series of higher highs and higher lows, while a downtrend is the reverse. Once a trend is observed, possible actions could be to bet on a trend continuation, a short term reversal inside the trend, or a bet on the break of the trend. Of course, it's impossible to know what the price will do in advance, but observing trends can give a trading edge: A significant upside with limited downside (or risk). And that's what technical analysis is all about. Not to be 100% right all the time, but to provide help with timing trades which give an edge to the trader and to tilt the odds slightly in your favor.

Robert Edwards and John Magee summarized these insights already in 1958 in their book "Technical Analysis of Stock Trends". Both authors already knew that stock prices are exclusively the result of supply and demand and mostly move in trends. Significant changes in demand and supply can cause trend changes. These changes can be observed in chart patterns. And these patterns repeat over and over.

Lastly, Technical Analysis helps in dealing with emotions. Often, it's hard to understand why share prices move the way they do. This amazing company that prints better and better results, all the news are great, everything else goes up—but your pick won't move up, or worse even, slightly decline. Or the reverse, the company is completely overvalued, is on the way to bankruptcy, has lawsuits piling up but just doesn't go down. We have all seen these examples where we get trapped in our world view where for some reason "the market" isn't seeing it. Technical Analysis helps to prevent you from these biases. A stock goes up? Join the trend to make money, or get out of the way. Don't die on the hill of righteousness as it doesn't pay in trading. Or, at least, if you know something others don't, Technical Analysis helps to prevent losing your shirt until your thesis plays out.

Technical Analysis is just one tool in the tool kit. But a versatile and powerful one.

What kinds of Technical Analysis Exist?

There are two main kinds of Technical Analysis, "Predictive" and "Reactive". Both only depend on observable historic data displayed as charts. So what is the difference?

Predictive Technical Analysis, as per its name, tries to make predictions about future market developments. Unfortunately, as with any prediction about the future, they are sometimes right and often wrong.

Reactive Technical Analysis, however, doesn't try to predict the future or claims to be always right. It just uses chart patterns and indicators to generate trading signals that present a good risk-reward ratio. Let's use a specific example, a stock price goes up to $95. Historically, $100 has already served as a resistance level twice over the past four months. So reactive technical analysis doesn't try to predict whether the resistance level will hold a third time or break. It would just flag this as an interesting trading opportunity, as a trader could either bet on another rejection near the resistance level or a break out to new highs, both with close stop-losses—an interesting risk-reward ratio!

Going forward, we'll focus on Reactive Technical Analysis as the main method to use.

How to use Technical Analysis When Trading

There are two main components to (Reactive) Technical Analysis. The first are chart patterns, and the second are indicators.

Using chart patterns follows a simple three-step approach.

  1. Know and identify chart patterns
  2. Understand the impact of patterns and how they resolve
  3. Bet on pattern developing while keeping risk in check

The most notable chart patterns include:

  • Support and resistance levels
  • Trend lines
  • Flags and pennants
  • Ascending/descending triangle
  • Symmetrical triangle
  • Cup and handle
  • Head and shoulders
  • Double bottoms

Most notable indicators include:

  • Moving averages
  • Volume
  • MACD
  • RSI
  • Bollinger bands