Technical Analysis is used by many trading the financial markets with some making trading decisions based solely on technical analysis. While the value of technical analysis is accepted by much of the wider trading community, there is a group of ardent critics who are very skeptical of technical analysis. In this post I want to outline some of the general criticisms regarding technical analysis.
1) There is no hard proof that technical analysis works.
Those who are critical of technical analysis often state that there is no hard proof that technical analysis works. However this claim is slightly nebulous due to the fact that it is not specific. It is clear that there can never be hard proof demonstrating that all technical analysis works or that certain methods of technical analysis will work for an indefinite period of time. In fact there seems to be evidence suggesting that the kinds of technical analysis that work change over time with different markets and time periods being suited to different methods of technical analysis.
Not only does this claim misunderstand the nature of technical analysis, it also appears to be false. There has been much research regarding technical analysis during the last few years and a number of studies have suggested that certain forms of technical analysis can be used to effectively predict price movements. So it appears that we can rebut the claim their is no evidence or hard proof regarding the effectiveness of technical analysis.
2) Technical Analysis works because it’s self fulfilling.
Another claim that is often made though less frequently, is that technical analysis only works because traders believe it works and therefore act accordingly. It seems easy to provide examples of technical analysis acting as a self-fulfilling propehcy. For instance many stock traders believe that when a stock falls below its 200-day moving average, its time to dump the stock. If enough traders believe this we should expect to see a significant fall in price when the said stock does fall below its 200-day moving average. With the large scale sell-off acting to further suppress the stocks price.
While this could sometimes be true, the sheer number of people and institutions trading the financial markets mean that such situations are very unlikely to occur. For instance Elliot Wave theory is one of the more popular forms of technical analysis among traders in the former Eastern Bloc, but has a much smaller following among traders in Western Europe. The sheer number of trading systems and strategies adopted by different individuals and institutions often precludes technical analysis from being a self-fulfilling strategy. It should also be noted that not all traders are influenced by technical analysis, with many traders instead adopting a sentiment or fundamental based approach to trading.
3) Price Changes are random and can’t be predicted.
This criticism is related to the Random Walk Theory made popular by Burton Malkiel in his 1973 book ‘A Random Walk Down Wall Street’. The basic idea is that price history is no accurate guide to future price direction, adherents to this view hold that financial markets are efficient. Essentially efficient market theorists hold that price fluctuates randomly around a particular intrinsic value. Market price reflects everything that can be known about a particular instrument. This is position which is in fact quite similar to one often made by technical analysts. The main difference being that adherents to the efficient market hypothesis hold the believe that markets react immediately to information effecting an instruments intrinsic price, while those who embrace technical analysis hold that such discounting ebbs and flows in a way which can be predicted by the use of technical analysis.
The efficient market hypothesis is itself very controversial and there seems to be good reason for rejecting it, at least in its strongest forms. While modern financial markets are incredibly inefficient they are not perfectly efficient, leaving for plenty of room for traders who use technical analysis a chance make to profit from price movements.
Technical analysis seems to be able to stand up against these three criticisms and it appears that technical analysis is a legitimate approach to trading the financial markets.