Technical analysis has always been rejected as a study of lines and charts without any real concrete or profitable results. And clearly, an exhaustive debate on its usefulness would be long-winded, especially against those that only subscribe to fundamental analysis, as Warren Buffett does.
But as any technician will tell you, it does work well with understanding.
Academics will tell you such analysis is impossible. In fact, according to Efficient Market Theory, it can’t work at all since all information available is already priced into the price of a stock. But even that’s ridiculous and untrue based on information friction.
Think about it. In today’s market, you may hear about great news at 10am, and buy the stock. I may learn about it at 2pm and trade it then. Efficient Market Theory doesn’t account for news traveling from local to regional to national to global.
First, let’s define what technical analysis is.
At its very core, technical analysis is the study of market behaviors, the psychology of fear and greed, which essentially drives all stocks. While fundamental analysis focuses on the nuts and bolts of a company’s engine, technicians are concerned with supply and demand, and points of support and resistance.
There are quite a few flaws in the arguments against technicians.
Myth No. 1 – Past Prices Aren’t Useful in Predicting the Future
One of the biggest critiques of technical analysis is that it can’t predict future prices. But when it comes to predicting future movements in stocks, the more a pattern – such as a double or triple top – repeats itself the more reliable it becomes as a predictor for future price movements. It allows us to identify important levels of charts and react to them.
For example, look at the triple bottom with Facebook (FB) below. Each time the stock falls to $115, we can argue that traders are supporting it at those prices and that we’re likely to see a higher price with patience.
10 Powerful Technical Chart Formations [PDF]
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Myth No. 2 – Technical Analysis is only good for Short-Term Trading
Nice try, but no. Analysts can plot charts for days, weeks, months and years to spot strong trends, for example. Even today, traders used the 50-day and 200-day moving averages as support lines to argue for sustainable long-term trends
For example, look at how powerful the 200-day MA has been with the iShares NASDAQ Biotechnology Index (IBB) since 2009. It held that support for years. After a sustained breakdown through that same moving average, we could argue for trend reversal and play it accordingly.
Myth No. 3 – Big Traders Don’t Use Technical Analysis
I’m not sure where some of these arguments came from. Large funds and investment banks make substantial use of technical analysis. High frequency trading for example is heavily dependent on it.
Myth No. 4 – Technical Analysis has a Low Success Rate
A look at long lists of successful traders debunks that immediately. Countless books would have never been published, such a Technical Analysis A to Z, if it didn’t work. Nothing has 100% accuracy. If it did, we’d all be rich. Fundamental analysis isn’t perfect either.
Let’s look at the head and shoulders technical pattern for example. Historically, it’s had a success rate of 83%. The regular head and shoulders pattern is defined by two swing highs (the shoulders) with a higher high (the head) between them. One formed in the price of oil in recent months, but failed because of OPEC news.
The triple top has a historical accuracy of 76% according to some sites. Triple bottoms have 79% accuracy. They’re not perfect. But then again not much is.
Myth No. 5 – You Have to Sit in Front of Your Computer All Day
Again, not true. The problem is that many traders don’t actively absorb, know what they’re looking for, or absorb what a chart is telling them. They’re too busy hunting for signals, instead of paying attention.
For example, take a look at this chart and tell me what Relative Strength (RSI), Money Flow (MFI) and Williams’ %Range (W%R) tell us every time the IBB finds support just under $250 a share. It tells us the ETF is oversold and ready to bounce, as it does.
There you have it. 5 common myths about technical analysis have been exposed and debunked. Hopefully, these observations will make a difference in your trading.
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