Technical Analysis
Is there any evidence in favor of technical analysis, or - as some fundamental analysts like to suggest - is it no better than a sophisticated superstition?
What is Technical Analysis?
Technical analysis (T.A.) has been around since at least the 1600s, when Japanese rice traders began using candlestick charts to track the market price of rice. The traders realized that certain patterns in their candlestick charts seemed to indicate that major price changes were imminent in the rice market. They tried to recognize the patterns that preceded large price movements.
Just as the rice traders did long ago, modern technical analysis uses a stock's price history to decide whether it should be bought, held or sold. Often the trading volume - the number of shares that have been traded - is included in technical analysis. Here we are going to consider price history alone.
Technical analysts believe rising prices means buyers are bidding confidently, convinced the price will rise further. This type of buyer is termed a bull in market jargon. A lack of conviction on the part of bulls leads to falling or flat prices. When prices are consistently falling, bears are said to be in control of the market. Bears believe prices will fall and they are sellers.
A basic premise of technical analysis is that, if there is momentum in a stock-price - in other words, if its price has been trending upwards or downwards consistently over a period of time - the momentum will certainly reverse some time - but probably not in the short term. Therefore, if momentum is positive you should buy - positive momentum leads to rising prices. Similarly, if momentum is negative, you should sell - negative momentum leads to falling prices.
Does Technical Analysis Work?
Firstly, it's important to say that no reputable Technical Analyst would claim their methods are effective for every trade.Some technical analysts look for a method that makes a profit on most trades. Making small profits on 60 to 70 percent of trades is possible. When these small profits are added up, they can be significant.
Other technical analysts employ methods that find fewer winning trades. Their strategy can still be profitable because they hold on to their winning stocks for as long as they continue to rise - leading to larger gains - while quickly offloading losing stocks, to minimize losses.
Proceed With Caution
Many T.A. methods do not work. Some methods are peddaled by modern-day snake-oil salesmen whose aim is to make their fortunes by selling dubious methods to a gullible public. The prospect of getting rich quick still seems to reel the suckers in.
John Mauldin reports that, in 1991, fund manager Gary Hirst began looking at all aspects of technical analysis. Hirst used a large research budget to investigate the effectiveness of various forms of technical analysis such as Elliot wave, stochastics and chart patterns. Hirst found no evidence that these methods outperformed a strategy of trading stocks at random times.
Amidst all the negatives, however, Hirst found a positive. Markets produce profitable trends.
Trend Following and Charts
Investingator's in-house analysis of a variety of T.A. methods was not quite as dismissive as Hirst's. We found that certain chart patterns were reasonably reliable as predictors of the beginning or end of a new trend. In fact Thomas Bulkowski has published the Encyclopedia of Chart Patterns. Bulkowski studied chart patterns used by stock traders in their decision making. Of the many patterns used, Bulkowski found several with failure rates of lower than ten percent.
Low failure-rate patterns included, for example, Ascending Triangles and Descending Triangles.
We also found other methods that seemed to yield a statistically significant positive return. However, they only yielded positive returns when applied to stocks that were already trending upwards. They added to the profits already available from buying upwardly trending stocks. The extra returns were, however, small.
In summary, there is abundant evidence that momentum / trend based technical strategies can be used successfully in stock-trading.
Other technical analysis methods can also be used profitably - we know traders who live comfortably on earnings from T.A. based stock-trading methods. Many, naturally enough, do not publicize their methods. There are, however, well-documented and enduring examples of successful T.A. based trading and investing.