‘Is technical analysis’- a ‘voodoo’ approach to investing?
The use of technical analysis for stocks has been around for a very long time. It was first developed to predict Dutch stock markets in the 17th century. Modern technical analysis and theories however have been refined and added to by many analysts including a ballroom dancer named Nicolas Darvas).
What Is Technical Analysis?
Technical analysis uses historical market prices and volumes of a stock or index. It assumes market psychology, behavioral economics, quantitative analysis, and past performance are part of investing behavior and can be used to predict future short and long-term market price movements and trends.
Key features of technical analysis:
· It identifies ‘patterns’ related to price movements and assumes certain patterns repeat.
· There are a multitude of patterns or indicators that could apply at any point in time.
· ‘Pattern’ identification depends on the ability to recognize the formation of a particular pattern.
· It assumes market and prices reflect all available information which is reflected in a price chart.
The most common technical analysis approaches are charting and technical metrics (statistical) indicators. Charting of daily stock prices is used rather than examining the fundamentals of a company. Both charting and technical metrics are used to identify entry and exit points for potential trades by extrapolating potential price ‘breakouts’.
The essence of technical analysis is the belief that prices move in trends and history tends to repeat itself. However, this needs to be taken with a ‘grain of salt’: the SEC requires fund managers and advisors to tell investors that a fund's past performance does not necessarily predict future results.
What does a ‘pattern’ indicate?
Technical analysis generally attempts to determine if a current trend will continue and when it will change. There is a multitude of pattern indicators such as trendlines, ‘candlestick’ formations, bands, boxes, ascending triangles, three black crows, etc. The identification and interpretation patterns vary with each analyst – it is not science!
Chart patterns are a subjective form of analysis that attempts to identify areas of ‘support’ (more buying) and ‘resistance’ (less buying) in a specific situation. These patterns supposedly reflect investor psychological factors and a possible breakout or breakdown from a specific price point and time. A breakout from a point of resistance could lead to a significant, high-volume price increase.
Technical indicators (Metrics)
Technical indicators or metrics use various mathematical formulas to analyze prices and volumes which include: MACD (Moving average convergence divergence), RSI( Relative strength indicators), ADX (Average Directional Index), OBV (On-balance Volumes), Bollinger bands, stochastic oscillators, and many more. Many trading systems used by fund managers use technical indicators as determine points of entry or sales.
Are Charting or technical analyses effective?
Both charting and technical metric approaches are complicated, and the results are often difficult to assess. However, many successful investors and professional money managers use fundamental or technical analysis and may use both approaches. Technical metrics tend to be a faster approach lending themselves to computers utilizing market data that can be downloaded rather than fundamental analysis which requires more time and is more expensive.
Both charting and technical metrics have limitations because of the dependence on interpretation and the common use of more than one indicator, charts can be misinterpreted, information may be based on low volumes, time periods used may be too long or too short, black swan events may occur which distort patterns, etc. Since interpreting and identifying patterns and information is subjective it is often referred to as ‘voodoo’ analysis (a phrase used to dismiss ambiguous economic or financial ideas).
Since technical analysis so prevalent in the investment world, and undoubtedly have some impact on the prices, it cannot be ignored. Voodoo or not, it pays to have a basic understanding of technical analysis.
Investopedia has identified the top 7 books and articles that explain technical analysis:
Information about technical analysis, however, should be taken with a ‘grain of salt’: the SEC requires fund managers and advisors to tell investors that a fund's past performance does not necessarily predict future results. It is debatable whether the price ‘ breakouts’ indicated by technical analysis materialize. Analysts are quick to point out success if a breakout occurs, but seldom comment when the ‘breakouts fail to happen.
Because of the subjective nature of the interpretation of technical indicators, it could also be argued that technical analysis is simply a case of pareidolia (the tendency to impose a meaningful interpretation on a nebulous stimulus, usually visual, so that one sees an object, pattern, or meaning where there is none”).