TWC Forex

Does Technical Analysis Work?

Posted on 03. Sep, 2010 by TWC Contributor in Forex

This is one of the most intense questions argued in academic circles and trading groups for years .  The situation is a rather simple one and goes as follows:

1.     The academic economist camp is deeply rooted in efficient market theory whose primary tenants include the opinion that price action in the marketplace is primarily random.  Since movement in the market is random, this would preclude the majority of the primary assumptions of technical theory, which states that there are identifiable patterns and formations that form in the market and can be identified .
2.     A growiong number of traders are devoted believers in technical analysis and rely upon this system to trade, especially day traders. Technical traders believe the market exhibits repeating formations, trends, and other factors that are identifiable and nonrandom. As you can see, technical theory is exactly opposite the basic assumptions of the efficient market theory and thus at odds with the beliefs of academia.

There is very little room to reconcile in this particular argument, as both sides of the discussion firmly believe in the method they employ.  Historically, academics have viewed technical theory and technical trading as voodoo trading and accorded the method little respect .  To be sure, I may even be understating the view of academics towards technical trading.  Traditionally, there has simply been no room in academic thought for the tenants of technical trading; they dismiss this style of trading as something akin to heresy.

On the other side of the argument , it’s risky to find a exact definition for technical theory and technical trading as there are dozens of flavors of the method of trading .  Some portions of technical theory are fairly traditional and easy to assimilate and others press the edges the absolutely bizarre.  To further confuse matters, there are dozens of mutations that fall somewhere between the exact opposite absolutes of technical trading.  And I think that’s a portion of the problem , because it’s nearly impossible to quantify exactly what technical trading theory truly states because of the differing range of variants in its implementation.  To make matters more complicated , most adherents to technical theory are as devoted to the theoretical underpinnings of their beliefs as the academics are devoted to efficient market theory.

It is truly a classic standoff.

While there are variants of efficient market theory, the basic assumptions run through most versions of efficient market theory.  Technical theory, on the other hand, is a assemblage of wildly divergent and wide-ranging trading methods that are difficult to assimilate under a single umbrella.  So that leaves me with the discordant job of sifting through technical methodologies and categorizing the varying theories and their probabilities. Of course, these views are based upon my own personal experience and belief .

1.     Support and resistance, pivot points, and trend lines: in my three these three mainstream technical indicators can be of great use.  I use a portion of my trading upon implementation, in varying degrees, of these technical tools.
2.    Chart formations: these would include the classic formations like head and shoulders formations, banners, and double and triple tops. This is one area academia has spent a great amount of time and effort to discredit.  My experience has not been in any way positive when trading using chart formations, though I have found them to be of limited use.
3.    Wave patterns, Gann lines, Elliott wave and other predictive tools: I believe these tools to be a very limited value and scientifically spurious .  There are many studies in the mainstream that would seem to completely disprove the value of these technical tools.  I should also point out there are a great number traders who claim to successfully trade using these trading techniques.
4.    Fibonacci retracement: when used properly Fibonacci retracements can be very effective and useful .  However, in my opinion Fibonacci theory has been used to justify dubious conclusion to ptove to a variety of situations.  The scientific evidence on the effectiveness of Fibonacci retracement is sketchy at best, and most academics dismiss them as hocus-pocus forms of trading.  I disagree with this assessment.

As you can see, I use some of the technical tools available and use the ones that I feel are effective .  Even though academics have discredited some of the technical tools that I use, I have found their accuracy to be contrary to the claims of some scientific study.  I can explain no cause for the disparity in the scientific claims versus my actual experience.  However, as a trader I am much more interested in what works than whether the scientific and academic communities assess these technical techniques as effective .  I suppose you could sum up my experience  with technical trading as a mixed bag, and I pick and choose carefully which technical techniques to implement in my day trading.

I teach a course on e-mini day trading with a remarkable level of success.  The tenants of the course are technically based and I pride myself on offering the course as an inexpensive day trading course for beginners.