While the computer age has brought technical analysis to the masses, it’s not a new concept. Used as long ago as the 18th-century by Japanese rice traders, its use has increased over time. Technical analysis still has its fair share of naysayers, but how does it affect the market?
Technical analysis affects the market by helping increase speculation in the markets, especially by individual traders. And because it’s the basis of some computer-driven trading, it adds to the market’s volatility.
However, modern markets are complex. So, while technical analysis may have an effect, rarely can we say it’s the sole cause. We’ll expand on what we mean below.
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Table of Contents
What Is Technical Analysis All About?
In brief, technical analysis is a rules-based way to analyze historical price information.
It uses chart patterns and indicators to predict future price movements.
Some practitioners swear by it alone. Others use it in conjunction with fundamental analysis to inform their trading decisions.
What seems clear is that its use in markets has increased over time. So, let’s look now at some ways technical analysis may affect markets.
Does Technical Analysis Make Markets Move?
It seems logical, doesn’t it? People using technical analysis are all looking at the same things. So, they’ll buy and sell at the same prices. Their combined action should move markets in a predictable way.
Take the example of a support level. If everyone is looking at the same thing and acting on it, the market should bounce.
Some Concepts Are Open to Interpretation
Unfortunately, it isn’t quite as simple as that. Sticking with the example of support levels, they can be a matter of interpretation.
You can see this from a study, titled – ‘Technical trading and cryptocurrencies’, by an economist at the New York Federal Reserve Bank in 2000. The study looked at whether support and resistance levels were effective reversal points. It used levels published by a handful of market players.
The study found that often, the levels published by each firm differed from one another. That’s because technical analysts use various ways to find support and resistance.
One analyst might just use the lowest and highest price points within a period. Those price points would come from a visual inspection of price action.
Another might look at round numbers. Often, such numbers are psychological support and resistance points.
Yet another might trade on market information that’s not public. An example might be knowledge of a large client order at a particular price point. If the order is large enough, it might provide support or resistance.
Also, there may be differences when it comes to acting on a signal. For example, some traders might buy or sell right at the price they’ve identified.
Others might first want prices to gap below or above it and then close with a complete retrace of the gap.
Yet others might consider the levels to be regions rather than precise points. So, they might only act if price doesn’t move below or above their level by a chosen percentage.
Not Everyone Uses the Same Indicator Settings
With technical indicators, traders have ample scope to customize settings. For example, let’s take the popular moving average. You can use a simple or exponential moving average to generate signals.
You can also change the period of the moving averages to trigger fewer or more signals. Further, some traders use only one moving average as a simple trend indicator. More often, they’ll use two and look for crossovers to mark trend changes. Some will even use three and more.
It’s the same with most of the technical indicators that come as standard in charting software. They are infinitely customizable.
So, technical analysts may be looking at the same charts and indicators. But, how they interpret what they see and the strategies they adopt may differ. So, there may not be enough of a consensus to drive the market in a particular direction.
That means technical analysis probably doesn’t move markets. Not everyone is acting on the same signals or at the same price levels.
Does Technical Analysis Increase Market Speculation?
It’s probably true that technical analysis may have increased market speculation.
Retail Investor Behavior Changed Over the Decades
There’s support for this in a 2013 Dutch study, titled – ‘The High Cost of Technical Analysis and Speculation’. Researchers looked at an earlier study about individual investor behavior in 1964-1970.
It showed most clients used fundamental analysis to make decisions. Also, their goal was long-term capital gains. That differed from those who used technical analysis. They tended to be looking for short-term speculative gains only.
The 2013 study compared that finding with investor behavior between 2000 to 2006. It found that the use of technical analysis amongst brokerage clients had increased. In fact, it was five times more common than in the earlier study. Further, 75% more of the time, the investors’ goal was speculation, not long-term growth.
While investor behavior may have changed, both studies found one thing in common. They both agreed increased technical analysis usage led to greater market speculation.
The studies also agreed on something else. Investors using technical analysis to speculate tended to over-trade. That proved counter-productive to the investors’ returns. But, on the plus side, it adds to a market’s liquidity, which is a good thing.
Technical Analysis Isn’t the Sole Driver of Increased Speculation
But, does this increased speculation have any significant impact on the market? It’s doubtful. After all, there have been many other developments in the markets over the years to drive it.
Not least, we’ve seen the growth in online trading and discount brokers. Also, such brokerages recently ditched their fees to attract more clients. That led to increased retail investor participation from 10% in 2019 to 15%, and now around 20%.
We’ve also seen the emergence of fee-free app-based trading platforms. They make it even easier for individual investors to get involved in the markets.
Such developments, coupled with social media, caused the 2021 frenzy around Gamestop shares. There wasn’t much technical analysis involved there. And, of course, there have been similar occurrences in the past, such as the dot-com bubble.
So, technical analysis may have played a part in increasing individual market speculation. But it’s not necessarily a bad thing. At least there’s a method. Other factors increasing speculation may be more of a problem to market stability.
Does Technical Analysis Make the Market Unstable?
One thing that technical analysis lends itself to is computer-driven trading. That’s trading using algorithms to find and execute trades. Such trading has been around for a while, and it’s still growing.
However, there is a concern surrounding algorithmic trading. The fear is that it can cause or contribute to instability in the market. In particular, the market crashes.
In fact, rule-based computer-driven trading was one factor that exacerbated the 1987 crash. And that was at a time when such trading was in its infancy compared to now.
Of course, since then, we’ve seen the flash crash of 2010, the speed of which surprised many traders. A better word may be shocking if the following video is anything to go by:
Other crashes occurred in August 2015, February 2018. Algorithmic trading may have played a part in all these events.
And then there was the big market drop in 2020. Some say algorithmic-trading helped speed up that decline.
But, technical analysis isn’t the only method driving algorithms and affecting markets. Far more complex algorithms may have contributed to the 2008 financial crisis. That crisis saw significant market declines.
So, technical analysis-driven algorithms may have played a part in market instability. However, those algorithms weren’t necessarily the only drivers.
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Conclusion
Technical analysis does affect the market. It’s said that it increases investor speculation, probably leading to excessive trading.
It also plays a role in algorithmic trading. There’s a belief that such trading can contribute to market instability.
However, markets consist of many layers of complexity. So, it’s unlikely that a single factor, like the use of technical analysis, can have a significant impact.
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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