Many people wonder whether technical analysis works or not. Can you really predict future price movement by using chart patterns, technical indicators, and statistical analysis? The opinions are divided - some claim that technical analysis is a proven trading system while others feel it's useless.
Clearly, there's no decisive answer to this question. It's subjective to an individual's beliefs and experience. Yet, in this article, we'll seek the best approach for you to use technical analysis and find ways to integrate it into your trading strategy.
Technical Analysis Explained - How Does It Work?
Before we make a statement on whether technical analysis works or not, we first need to understand what technical analysis is and how it really works. In its simplest form, technical analysis is a method to predict future stock price movements by analyzing past price action. So far, not something revolutionary, right?
Let's dig deeper. Technical analysts believe that everything lies in the charts. It has three key principles and technical trading rules:
- The market data always discounts everything.
- Prices move in trends.
- Price action is repetitive, meaning different chart patterns reoccur and signal entry and exit levels.
So, instead of analyzing the intrinsic value of a stock, a currency, or a commodity - a technical analyst can receive all this information on the chart by focusing on the price action and market volume.
But more than that, as we mentioned, the idea of technical analysis is to find repetitive chart patterns that indicate a particular trend. So, for example, when traders identify a Doji candlestick pattern, they might interpret it as the end of an existing trend movement and a beginning of a new trend. On the other hand, traders can also identify continuation chart patterns like the Bullish Rectangle chart pattern to enter a bullish uptrend following price consolidation.
Additionally, technical analysis traders use various indicators and support and resistance levels to find entry and exit levels. For instance, a Relative Strength Indicator (RSI) indicates that the market is in an overbought or oversold situation, and the trend might reverse. Moreover, many traders use Fibonacci retracement support and resistance levels to find potential traders.
So, Does Technical Analysis Work?
Well, as we previously mentioned, it's all subjective and depends on the type of trader you are and your trading style. Long-term investors and fundamental analysts typically do not rely on technical analysis as they aim to evaluate the true value of an asset. Therefore, if they need to analyze a specific currency, they will look for the strength or weakness of the currency's economy. Or, if they try to predict if a stock price might rise or fall, they will look at the company's earnings and other fundamental factors.
On the other hand, day traders cannot avoid technical analysis (especially when there are so many technical analysis software in the markets these days). While fundamental analysis is the holy grail for investors, day and swing traders usually rely heavily on technical analysis. After all, looking at charts is the best way to analyze the markets as you get a clear visualization of each price movement. Even without using common and popular technical analysis chart patterns and technical indicators, you inevitably be able to find charting patterns and various indicators that might help you analyze the markets.
This way or the other, technical analysis is a discipline with strict rules and key principles. Using technical analysis incorrectly may, in fact, lead to losses. But does it work? Is technical analysis reliable? Well, of course it is. It is simply a tool that helps traders (and investors) to predict future price movements and analyze the markets.
Nonetheless, despite all the merits of technical analysis, a trader using only technical analysis will most likely fail and lose money. By all means, the ideal strategy to trade financial markets is to integrate technical and fundamental analysis.
The Bottom Line
The bottom line is that every trader should use technical analysis to reconfirm trading decisions rather than take the decision. And technical analysis is a broad and diverse term that includes chart analysis, patterns, indicators, support and resistance analysis, volume, etc.
Ultimately, it all depends on the skills and experience a trader gains to absorb the information and interpret it for profitable trades. Some studies show that those traders who use technical analysis are more likely to become speculative traders that overtrade the markets. Other studies tell you that there's a huge benefit to using technical analysis and it is, indeed, a valuable tool.
One study found that hedge fund managers who used technical analysis "appear to have provided a meaningful advantage to their investors". It's hard to ignore that TA has many benefits to its side. Just like any other field in life - from religion to politics to the economy and social justice - it all comes down to using the discipline correctly rather than finding out if the system works or not.