Have you ever tried driving a car by looking in the rearview mirror? That’s how some critics might describe the use of technical analysis of the stock market. But does technical analysis work in stock markets?
Technical analysis works in the stock markets, but it doesn’t predict certainties. Sometimes, it doesn’t work, but it can identify high-probability trading opportunities. Over time, those opportunities coupled with a disciplined approach can provide profitable returns.
What does this boil down to? It’s about recognizing that technical analysis isn’t a money-making panacea, but we’ll explain that in this article.
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Table of Contents
What Does Technical Analysis Involve?
Technical analysis involves studying past prices and volume to predict future price movements. It’s based on the belief that prices form recognizable patterns, which might suggest a future price direction. Some also use indicators derived from prices to help their assessment of what price might do next.
Well-known chart patterns include the likes of double tops and bottoms or flags. Indicators include moving averages and channels.
Technical analysis assumes that price discounts all information that may influence its movement. All price-related factors, whether political or economic, are already in the price.
Does Technical Stock Analysis Work?
There is much research into whether technical analysis works, but there are no definitive conclusions. Still, most modern studies have found that technical analysis can provide profitable returns. Those studies looked at various speculative markets like the stock markets.
The balance of the evidence tells us that technical analysis does work in stock markets. But there’s no guarantee it will work on every market, and it’s unlikely it will work all the time.
For example, a 2018 study, titled – ‘Examination of the profitability of technical analysis based on moving average strategies in BRICS’, looked at the profitability of trading moving average signals on various BRICs markets. It found significant divergence in the performance of these indicators between markets, so in some markets, the moving averages worked well, while they didn’t work in others.
Now, that doesn’t mean technical analysis doesn’t work at all in those markets. All it shows is that some indicators may not work in particular markets. No study to date has done a comprehensive test of all indicators and patterns on every market.
Indeed, a 2020 study of the currency markets, titled – ‘The profitability of technical analysis: Evidence from the piercing line and dark cloud cover patterns in the forex market’, made similar findings. The chart patterns used in that study worked well with some currencies but not others. Even where the patterns did work, they didn’t give positive returns all the time, while many were losing trades.
It’s a misconception that if technical analysis works, it must be right all the time. This kind of reasoning and other issues can leave you thinking that technical analysis doesn’t really work in the stock market.
We’ll look at these issues next.
4 Limitations of Technical Analysis That You Must Know
Technical Analysis Isn’t a Crystal Ball
It’s worth discussing this, as it’s a major source of misunderstanding about technical analysis.
Technical Analysis Doesn’t Guarantee Future Price Movement
If technical analysis could tell you with 100% accuracy what the stock market will do next, you probably wouldn’t be reading this article.
Sadly, it doesn’t. Technical analysis won’t tell you what will happen, as it can only guide you as to what might happen. It doesn’t guarantee an outcome, so if you use it thinking it does, you’re going in with a mindset that will guarantee only one thing: failure.
When the market doesn’t move as expected, it’s not that technical analysis doesn’t work. It’s just that it didn’t play out on that occasion, as the results in the 2020 study above illustrate the point.
There were many instances when the indicators gave negative returns. In fact, there were more losing trades than winning trades, but over time, that didn’t matter. The strategies showed significant profitable returns.
So, with technical analysis, you won’t win every trade, but that doesn’t mean it doesn’t work.
Protect Yourself Against Being Wrong
When using technical analysis, you must be alert to the possibility that things might not work out as expected.
If you want a technical analysis of the stock market to work for you, you need a plan for when the market moves against you, so you can know when to get out of the trade to protect your capital.
Without that, technical analysis won’t work over the long term unless you’re that unique being who’s never wrong. Spoiler alert: there’s no such thing.
Technical Analysis Is Open to Interpretation
Much like beauty is in the eye of the beholder, so too, price patterns on a chart.
There are times when one technical analyst might draw different conclusions than another, even if they’re both looking at the same chart.
It’s because the technical analysis can be subjective. To some extent, this is unavoidable, but that’s where having a defined exit point before you enter a trade can help, which will limit losses if your interpretation is wrong.
Another issue is that markets don’t always move in textbook fashion, so that perfect head and shoulders pattern in your encyclopedia of chart patterns may not look so perfect in real life.
In those situations, the temptation is to think the pattern you’re seeing is close enough. So, you trade it. Of course, it may work, but if the pattern doesn’t set up as its rules say it should, you’re taking a risk if you trade it. The more you do this, the higher your risk.
What’s the solution? The best thing is to only trade patterns that conform to the rules. Try not to be too flexible in your interpretation. Of course, you might end up missing a good trade, but the other side of that coin is that you’ll avoid incurring a loss.
Failing To Test Indicators Can Lead to Failure
If you’ve ever looked at the indicators that technical analysts use, you’ll know that many of them have adjustable settings. For example, with moving averages, you can switch between a simple or exponential moving average, or adjust the length of the moving average.
These adjustments can alter when crossovers between the shorter and longer moving average occur, which are the trading signal of this indicator. The risk is you play around with settings until you find something that works for a specific turning point in price. So, you jump into the setup for real, but it fails miserably.
You’ve found out the hard way about the importance of backtesting.
Seeing that your settings worked at one turning point isn’t enough. To select the correct indicator settings for your chosen market, you need to test them over a long enough historical period. In the 2020 study above, researchers tested the indicators with nineteen years of data.
If you see consistent positive returns from particular settings, only then try them out for real. Otherwise, change the settings and test again.
This type of testing can also reduce the risk of adjusting your indicators until they tell you what you want to see because you have a bias. Obviously, bias is necessary to enter a trade in one direction or another, but you want your analysis to give you that bias, rather than your bias giving you the analysis.
Technical Analysis Can’t Win Over Bad Discipline
As you’ve already seen, when you trade the market, you need to know when to get out because your analysis is wrong.
However, it can be hard to watch the market move against you and hit your loss-making exit point. The temptation is to adjust your exit point to avoid the loss, hoping that the market will turn and move back in your favor.
There are times when the market will do just that, which will only help reinforce your lack of discipline the next time. But, eventually, this type of behavior can get you into big trouble.
If you want the technical analysis to work, you need the discipline to listen when it tells you you’re wrong. Take the loss and move on.
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Conclusion
Technical analysis works in stock markets, but just because it doesn’t work all the time doesn’t mean that it detracts from its value when used correctly.
That means you should backtest your strategies to find what works in your chosen market.
Also, know at what price level your analysis is wrong and set an exit price, then follow the old stock market adage: plan your trade and trade your plan. Don’t adjust the plan to avoid taking a loss.
Do that, and over time, technical analysis in the stock market can reward you well.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
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