There is a strong opinion that if the stock market is operating in the strong form, this will not make the role of technical analysis redundant as markets
will not operate in the strong form forever.
Technical analysis involves the use of charts and technical indicators to predict the movement of a particular market. Many people (called technicians) swear by this approach to price forecasting while others (called fundamentalists) won't touch it. Most traders know that technical analysis has its advantages and strong points, but that it also has limitations. Many traders use charting methods alone while others use a combination of approaches.
Technicians, chartists or market strategists, as they are variously known, believe that there are systematic statistical dependencies in asset returns - that history tends to repeat itself. They make price predictions on the basis of published data, looking for patterns and possible correlations, and applying rules of thumb to charts to assess 'trends', 'support' and 'resistance levels'. From these, they develop buy and sell signals.
Market timing is a form of technical analysis that aims to identify turning points in the performance of major stock indices. Other methods include filter rules, measures of 'relative strength', line and bar charts, moving averages of prices over various periods, the study of trading volume, aggregate demand and supply analysis and numerous other gauges that measure momentum, valuation, sentiment, leadership or monetary policy.
MARKETS ARE DRIVEN BY PSYCHOLOGICAL FACTORS AND BELIEFS
Technical analysis is based on the assumption that markets are driven more by psychological factors than fundamental values. Its proponents believe that asset prices reflect not only the underlying 'value' of the assets but also the hopes and fears of those in the market. This is called investor psychology .They assume that the emotional makeup of investors does not change, that in a certain set of circumstances, investors will react in a similar manner to how they did in the past and that the resultant price moves are likely to be the same.
Technical analysis may also be an intuitive art form. There is an infinite range of data to look at and a sweep of global market history but the sorting is personal to the strategist. The skilled practitioner looks at the tea leaves, mulls over the past and may see into the future. But if you try to convert the art form into a mechanical, repetitive pattern, then the risk is that the art - and the forecast - is lost. Technical analysis looks more repetitive than it is.
The best forecasts are the ones that challenge conventional wisdom. But to do so requires strong conviction and may not be commercially successful unless one presumes to be right hundred percent of the time. And even in this unlikely event, telling your clients that they are wrong over and over is unlikely to produce high repeat subscription rates. So a high success rate can be a pyrrhic victory.
LET'S EXAMINE THE BENEFITS OF TECHNICAL ANALYSIS
Technical analysis focuses on buying and selling trends.
Volume, oscillators and momentum give a clearer picture of market action. And this information can be obtained at a glance. Technicians do not use economic reports that analyze the demand for a stock.
Trends are easily found.
Taking a look at a moving average line quickly displays a price that is trending or stuck in a range. Whether it is up, down, or sideways, a chart can quickly display a stock that is exhibiting a trend. Trends are critical to technicians because a currency is likely to continue moving in the direction of the trend. Charts show them clearly and quickly.
Patterns are easily identified. Market repeats itself.
One of the basic tenets of market action is that it repeats itself in clear, unmistakable patterns. Using charts helps the trader to find patterns and predict price movements based on these patterns. Like star constellations, patterns can be complex and complicated.
Head-and-shoulders patterns, rounding tops and bottoms, ascending and descending triangles, and double and triple tops are proven patterns that many market prices will follow. Hence, they have strong predictive powers. They can be impossible to detect without using a chart.
Charting is quick and inexpensive.
Computers have relieved us from the burden of performing complex mathematical operations. The Internet has a wealth of different technical indicators available that can help the trader to make more profitable and more reliable trades. Many brokers offer these types of technical indicators to their clients as part of their package.
Technical analysis is less time consuming and less costly than fundamental analysis. It can be performed in less than five minutes and the services are very often offered for free or at a nominal cost.
Charts provide a wealth of information.
Charts and indicators can provide a huge amount of information in only a few moments. Trends are easily found. Support and resistance levels are quickly identified. Momentum, volatility, and trading patterns appear quickly and easily. There are more than fifty kinds of indicators and they each provide information on different aspect of how a currency is moving. This information is critical to technicians to make sound and profitable trades.
Charts tell a story about the personality and price movement of a stock. The story can be complex with many different plots and twists or quite simple with only a few characters and single narrative. Charts are the same way. They can provide only the most basic information on a trend or support and resistance. However, they go much deeper to provide information on the strength of a trend, how momentum is building, and whether formations are developing that the can be traded.
BUY SIGNAL
SELLSIGNAL
These are just examples of how a chart of technical analysis can help people make decisions to buy or sell a certain stock. Based on these decisions people can make huge profits or stop losses. This proves that markets discount everything except information generated by market action, and all that they need is data generated by market action.
TECHNICAL ANALYSIS INVOLVES MANY ASPECTS INCLUDING:
CHARTING OF PRICE AND VOLUME
COMPUTER SOFTWARE ANALYSIS
TRENDLINE APPRAISAL
PATTERN RECOGNITION AND ANALYSIS
STUDY OF MARKET BREADTH
MATHEMATICAL COMPUTATION INCLUDING MOVING AVERAGES
WHY IS TECHINICAL ANALYSIS SO POPULAR?
If the weak and strong form of the efficient market hypothesis holds, then technical analysis has no value. If a market price follows a Markov process then technical analysis has no value. Why, then is technical analysis so popular? People often predict future uncertain events by taking a short history of data and asking what broader picture this history is representative of.
"This is a heuristic known as representativeness (Tversky and Kahneman 1974").
Technical analysis is representativeness. Below are some more psychological
Explanations of why a large number of people have a strong belief in technical
analysis.
Communal Reinforcement is a social construction in which a strong belief is formed when a claim is repeatedly asserted by members of a community, rather than due to the existence of empirical evidence for the validity of the claim.
Selective Thinking is the process by which one focuses on favourable evidence in order to justify a belief, ignoring unfavourable evidence.
Confirmation Bias is a cognitive bias whereby one tends to notice and look for information that confirms one's existing beliefs, whilst ignoring anything that contradicts those beliefs. It is a type of selective thinking.
Self-deception is the process of misleading ourselves to accept as true or valid what we believe to be false or invalid by ignoring evidence
of the contrary position.
LITERATURE REVIEW
Brown and Jennings (1989) showed that technical analysis has value in a model in which prices are not fully revealing and traders have rational conjectures about the relation between prices and buy and sell signals.
Frankel and Froot (1990) showed evidence for the rising importance of chartists. Neftci (1991) showed that a few of the rules used in technical analysis generate well-defined techniques of forecasting, but even well-defined rules were shown to be useless in prediction if the economic time series is Gaussian. However if the processes under consideration are non-linear, then the rules might capture some information. Tests showed that this may indeed be the case for the moving average rule.
Taylor and Allen (1992) report the results of a survey among chief foreign
Exchange dealers based in London in November 1988 and found that at least
90 per cent of respondents placed some weight on technical analysis, and that there was a skew towards using technical, rather than fundamental, analysis at shorter time horizons.
In a comprehensive and influential study Brock, Lakonishok and LeBaron
(1992) analysed 26 technical trading rules using 90 years of daily stock prices
from the Dow Jones Industrial Average up to 1987 and found that they all
outperformed the market.
Blume, Easley and O'Hara (1994) show that volume provides information
on information quality that cannot be deduced from the price. They also show
that traders who use information contained in market statistics do better than
traders who do not.
Lui and Mole (1998) report the results of a questionnaire survey conducted
in February 1995 on the use by foreign exchange dealers in Hong Kong of fundamental and technical analyses. They found that over 85% of respondents rely on both methods and, again, technical analysis was more popular.
Neely (1998) reconciles the fact that using technical trading rules to trade
against US intervention in foreign exchange markets can be profitable, yet, longterm,the intervention tends to be profitable.
LeBaron (1999) shows that, when using technical analysis in the foreign
exchange market, after removing periods in which the Federal Reserve is active,exchange rate predictability is dramatically reduced.
Lo, Mamaysky and Wang (2000) examines the effectiveness of technical analysis on US stocks from 1962 to 1996 and finds that over the 31-year sample period, several technical indicators do provide incremental information and may have some practical value.
One criticism I have is that beating the market in the absence of costs seems of little significance unless one is interested in finding a signal
which will later be incorporated into a full system. Secondly, it is perhaps naïve to work on the premise that 'bull' and 'bear' markets exist.
Neely and Weller (2001) use genetic programming to show that technical
trading rules can be profitable during US foreign exchange intervention.
Cesari and Cremonini (2003) make an extensive simulation comparison of
popular dynamic strategies of asset allocation and find that technical analysis
only performs well in Pacific markets.
IS TECHINICAL ANALYSIS SELF FULFILLING?
Is technical analysis self-fulfilling or self-destructive? A priori, I hypothesize
that if one conditions on price, then technical analysis is self-fulfilling; and if
one conditions on time, then technical analysis is self-destructive. The evidence for the former includes the success of support and resistance, and the evidence for the latter includes the documented erosion of calendar effects.
IN WHICH MARKETS DOES TECHINICAL ANALYSIS WORK?
For reasons of market efficiency one would assume that there is no privileged market. Due to risk aversion, investors require a small positive expected
return in risky markets. In long-only markets-like a stock market-this implies a positive upward drift. In symmetric markets which traders are as likely to be long as they are short, like futures and foreign exchange markets, the implication is that one would expect the price to be predictable to some degree. However, a buy-and-hold strategy in the stock market should make money because stock markets are a positive sum games, whilst the same can not be said for futures or FX markets.
Technical analysis can be adapted to any situation and applied to any type of trading and time frame. The technical analyst would be hard pressed to find a trading arena that these principles would not apply to. A technical analyst dealing with commodities can apply his or her principles to as many markets as needed, unlike the fundamentalist who will always concentrate on one market, such as gold because of the tremendous amount of data that needs to be processed.
Technical analysis also has uses in the field of economic forecasting. The commodity research bureau index has always been used as a leading indicator of inflationary trends. It has a close relationship with industrial production; commodity prices being spearhead movements in the index.
CONCLUSIONS
Publication bias should not adversely affect the relative performance of technical analysis, such as comparing different techniques, or different markets.
Excellent review paper by Park and Irwin (2004) does precisely that. The literature review undertaken here together with Park and Irwin's results give rise to the following conclusions:
• There is evidence in support of the usefulness of moving averages, momentum, support and resistance and some patterns; but no convincing
evidence in support of Gann Theory or Elliott Wave Theory 2.
• Chart patterns work better on stock markets than currency markets.
• Non-linear methods work best overall. This is not at all surprising in
light of the non-linearities found in markets (Hsieh 1989; Scheinkman and
LeBaron 1989; Frank and Stengos 1989; Brock, Hsieh and LeBaron 1991;
Abhyankar, Copeland andWong 1995; Brooks 1996; Abhyankar, Copeland
andWong 1997; Barkoulas and Travlos 1998; Ammermanna and Patterson
2003).
