The Problems with Technical Analysis

Of course, it’s easy to tell you all these things but how do you know that what I’m saying is true and works? At its most basic, all we can tell from charts and technical analysis is what happened in the past, as that is all they are showing us; why should we think that they have anything to say about where the prices are going in the future?

We accept without question that, for instance, weather forecasting is reasonable. If a cold wind is predicted from the North, then we might plan to delay an outdoor picnic to another day. If the weatherman says it’s going to rain, we might take an umbrella. Does it rain? Not necessarily, but we tend to believe that the weatherman get it right more than wrong.

It’s really just the same with technical analysis. Of course we don’t know the future, the same as we don’t know what weather is coming, but we are looking for likelihoods or probabilities of price movements. We’ll talk about psychology later, but the take away from this is that you must expect to lose some trades even though you did nothing wrong and your system is working fine. That is one of the mental barriers that you need to learn to deal with if you are to become a successful trader.

Just as you can with weather forecasting, you can show that technical analysis increases your odds of knowing what’s going to happen. Another topic for later is that of “back testing”– when someone develops a way of trading, a trading system, they often will back test which simply means checking how the system would’ve performed over previous years, to make sure that it does come out with a profit.

Efficient Market Hypothesis

Some people talk about the Efficient Market Hypothesis as if it proves that no one can make a profit from trading. In case anyone challenges you, you probably should know about it, but you also need to know that it has been disproved in practice even though it comes up time and time again.

This pessimistic view of the trading profession says that it’s impossible to beat the market because the market prices already include all that can be known. In other words, you cannot find undervalued stocks. The best an investor can do is to buy and hold, hoping that the company will grow and therefore increase the stock value over time.

Some people think that this means that the market price for stock is always right. It doesn’t. It simply means that if the price is wrong, too high or too low, there isn’t a way to tell which it is. This hypothesis includes the idea that markets are random, so it’s futile to try and forecast where prices are headed.

In a famous book, “A Random Walk down Wall Street” in the 70s, the idea was put forward that stock prices move randomly, again with the conclusion that you can’t tell where prices are headed just from looking at the past. This was development of the Efficient Market Hypothesis. There are still some people that believe this, even though it is easy to point to trends in prices that disprove it.

The crazy thing about the Efficient Market Hypothesis is that if everybody thought it was true then no one would analyze the market anymore, and that would mean that the market would not be “efficient”! No one analyzing it means no one is setting the price on the basis of all the known facts. So to believe in an efficient market you also have to believe that some people do not accept it and go on analyzing to try and beat it.

The Self Fulfilling Theory

It’s worth spending a little more time thinking about whether the market is self-fulfilling, which means everyone is following technical analysis, expecting and thereby making the results that it shows. This idea says that if all traders know technical analysis in a trade as if the results are true, and that makes them happen. For example, if everyone thinks the price is going up then they will be prepared to buy at a higher price and that makes the price go up. If everyone is sure the price is too high, then sellers will be glad to accept a little less and buyers certainly won’t pay too much, which will tend to push prices down.

Sounds like a very plausible theory, and honestly if it is so, who cares? After all, if the prices are going where you expect and hope them to when you trade, then you’ll make a profit, and who’s to say why they went that way? It’s not really that simple and here’s why.

There’s a lot of skill to technical analysis. Some say it is as much an art as a science. It’s not like engineering, where you plug in some numbers and know the results to expect, there’s always that element of uncertainty. Later on we’ll talk about chart patterns, and you’ll see that even these are subject to interpretation, and where one trader sees a pattern another will not. You have to train your eye to see what is there, not what you might like to think is there.

So what this means is that there is no uniform reaction from traders to any particular chart pattern. After all, if everyone could interpret the pattern the same way, then everyone would be making their fortunes. We’ve already discovered that the majority of traders lose money. Even amongst traders who believe that they have found a possible trade, each will bring their own interpretation to it. Some will wait until they see a clear sign, a confirmation, of the way the price is going, while others may try to jump the gun and anticipate it earlier in order to maximise their profits. It may depend how “lucky” they are feeling on the day, and how much risk they like to take on. Whatever the reason, there won’t be a concerted move at a particular time.

So it’s not likely that there is a self fulfilling aspect to the technical analysis of the prices. In truth, the markets are only driven by supply and demand, and there are many more market participants than just traders.