“In theory there is no difference between theory and
practice. In practice there is.”
In this article, I will briefly discuss whether Technical
Analysis works from a theoretical approach. In another article, I will try to evaluate
it from an empirical approach – one of the reasons for this blog. As I have set
up buy and sell targets, any of us can check the level of accuracy. TA, not
being a science, need not be 100% perfect. But at least we can get a number
(from my previous experiences, I have observed that it works 60-70% of the time
and if the rest “failed” trades are closed with “tight” stop losses, then the
trader can survive in the market). Now back to a more boring discussion – thus,
I will keep it short.
What is Technical Analysis? It
is a security analysis methodology for forecasting the direction of prices
through the study of past market data, primarily price and volume (from
Wikipedia). The basis of TA is:
- Market action (price) discounts
everything: Technicians believe that the current price fully reflects all
available information.
- Prices move in trends: That is
price movements are not totally random.
- History
tends to repeat itself: Technical analysts believe that investors
collectively repeat the behavior of the investors that preceded them. Because
investor behavior repeats itself so often, technicians believe that
recognizable (and predictable) price patterns will develop on a chart.
Source: Wikipedia
Technical Analysts are also “derogatively” called Chartists
as Technical Analysis is mainly based on Chart Patterns – flags, triangles,
Head and Shoulders, etc. It also uses candlestick (again pictures). However,
there are also some Mathematical functions - mainly Fibonacci Ratios which are
applied on the charts. There are also many derived metrics (called Technical
Indicators like RSI, MACD, etc) which indicate market movement.
From these, Technical Analysts try to predict what might
happen in future. Different analysts use different patterns based on their
personal preferences and risk appetite. Thus, analysts differ in their
perception and use of Technical Analysis. For example I am comfortable with a few
patterns – which I have seen repeat over time – I trade these and leave other
possible “bullish” patterns I am not comfortable with – however, I try to adopt
them over time also. Others use different patterns and are successful too – I have
heard of a couple of analysts who have >90% accuracy.
Does this mean that only Technical Analysis will do? I don’t
believe so. One needs to understand the Fundamentals too. Also money management
is very important. And one also needs Luck.
The best proof would have been if there was a mutual fund
that only ran on TA – then it could an “experimental” group – and its
performance could be compared with other (control group) mutual funds which
only ran on Fundamental Analysis. Does anyone know of such a fund run on TA –
it would be great to work there!
In the following link, one will get an excellent analysis on
Whether Technical Analysis works in Dhaka Stock Market. It seems the result is
positive.
I hope the Authors will not mind as I have used their
Analysis without their permission!
“In theory, theory and practice are the
same. In practice, they are not.”
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