The cult of technical analysis and day trading seems to grow and grow. The Web is crawling with technical analysis (TA). Tax changes have created a boom in spread betting, and hundreds of courses have sprung up to teach traders to read short term 'technical' chart set ups. All of this - coupled with the ongoing use of the terminology by market commentators and practitioners - may make you wonder whether technical trading rules are profitable and whether an investor not using them is missing out.
The short answer is no, not really, at least not in developed markets like the US or the UK. This isn't to say that there couldn't be some technical indicator out there somewhere that might work consistently in some market. But if there is, it's escaped the attention of any rigorous academic study on the topic that we've come across, especially for stocks. Furthermore, most of the popular TA indicators that are bandied around are not predictive and should probably be ignored.
So what is Technical Analysis?
Technical analysis is the forecasting of market prices by means of analysis of data and charts generated by the process of trading. Its origins can apparently be traced to the seminal articles published by Charles H. Dow in the Wall Street Journal between 1900 and 1902. Technicians believe that certain chart formations and patterns will indicate market psychology about either an individual stock or the market as a whole at key turning points. This is based on three key assumptions:
- Market action discounts everything - A fundamental principle is that a market's price already reflects all relevant information (including external drivers such as economic, fundamental and news events), so you just need to know the history of a security's trading pattern to predict its future pattern.
- Prices move in trends - Technical analysts believe that prices trend directionally, i.e., up, down, sideways or some combination.
- History tends to repeat itself - Technical analysts believe that price action also tends to repeat itself because investors collectively tend toward patterned behaviour. Because investors collectively repeat the behaviour of the investors that preceded them, technicians believe that recognisable (and predictable) price patterns will develop on a chart.
With those assumptions under their belt, technicians use charts search for archetypal price chart patterns (e.g. the well-known head and shoulders or double top/bottom reversal patterns) and…