Few industries have more polarizing topics than the financial markets. Technical analysis is one of such topics, triggering debates regularly across many investment and trading related communities. Some believe it is profitable, while others don’t. What’s the truth?
Technical analysis is profitable when used correctly, because it is effective in helping traders identify and trade asymmetric setups with favorable risk to reward ratios. However, the success potential hinges heavily on the technical approaches adopted and the trader’s ability to stay disciplined.
To understand how technical analysis can be profitable and effective, read on.
IMPORTANT SIDENOTE: I surveyed 1500+ traders to understand how social trading impacted their trading outcomes. The results shocked my belief system! Read my latest article: ‘Exploring Social Trading: Community, Profit, and Collaboration’ for my in-depth findings through the data collected from this survey!
Table of Contents
What Is Technical Analysis?
Technical analysis refers to the practice of analyzing the historical price movements of any instrument to make an actionable and risk-defined prediction on its future price movements. Technical analysts rely on charts and technical indicators to make their deductions.
Japanese candlesticks often form the foundation of these charts, but some technical analysts also use line and bar charts. Some of the popular technical indicators used include Exponential/Simple Moving Averages, Bollinger Bands, Stochastics, Moving Average Convergence Divergence, Parabolic SAR, and more.
Is Technical Analysis Profitable and Effective?
Technical analysis is profitable and effective. There are many documented examples of traders that built their fortune by strictly using technical strategies. One of the most publicized cases is the Turtle Traders story featuring legendary traders William Eckhardt and Richard Dennis. They ran an experiment to show that anyone can be taught to trade, with their students making over $175 million in five years.
The internet is awash with dozens of other traders that generated excellent returns using technical analysis. Some hedge funds using algorithms in their trading also rely on technical analysis. Without technical indicators, it will be hard to create the command lines most of the algorithms have to work with.
In the world of retail trading, a vast majority of traders rely on technical analysis to compete in the market.
What Are the Arguments Against Technical Analysis?
As we mentioned at the start, there are many opinions and postulations suggesting that technical analysis is not effective. Some of the arguments they commonly push include the following:
Technical Analysis Can’t Predict the Future of Price
This statement lacks any merit because no other forms of analysis are certain about the future of any asset’s price. Unpredictability is the foundation of the markets. Any good methods of analysis can only help you make more right predictions than wrong ones over time. To be profitable in trading, you only need your technical analysis to give you a statistically high chance of success in the market.
Technical Analysts Can’t Compete With Professional Desks and Firms
The point of technical analysis isn’t to compete with the big banks and professional desks. No retail trader can match up to them (especially in terms of trade execution) regardless of the type of analysis in use. Savvy technical analysts only use strategies that can help them make money consistently in the market.
In terms of pure numbers, many retail traders casually achieve a yearly return of 50% or more. Most big banks and professional desks will be ecstatic to generate anything more than 15% in any year. Granted, the size of the funds plays an important role, but it shows how both divides have different goals, and thus, shouldn’t be compared in any serious argument.
Technical Analysis Is Subjective
While this is true, fundamental analysis is even more subjective. Different fundamental analysts can analyze the same data cache and come up with different submissions on the underlying asset’s direction. Technical analysis is no different. Two traders looking at the same charts can settle on different market directions based on their tried and tested strategies. Most importantly, they can both make money from their respective decisions!
The subjective opinion of market participants is one of the main drivers of market movement and liquidity, so it shouldn’t be a negative talking point against any specific method of analysis.
How Can You Make Technical Analysis Effective for You?
There are two main ways to make technical analysis work for you. They include the following:
Create a Robust Strategy
A robust strategy is an all-encompassing description of your trading approach using technical analysis tools. The best strategy for you must, first of all, agree with your temperament as a trader. For example, if you don’t have the time to sit in front of your computer all day, or simply don’t have the mentality to chase small price fluctuations, your strategy shouldn’t involve a scalping or day trading approach.
To get the right strategy, here are the steps you should take:
- Decide if you’d prefer if you’d like a day trading approach or a longer-term one.
- Look for technical indicators or chart patterns that show promise in identifying setups. You can tweak existing approaches or create yours from scratch.
- Work out the best money management principles for the strategy.
- Backtest thoroughly to see how the strategy held up in the last 10-20 years.
- Once satisfied, adopt the strategy.
So, a good strategy should cover the following:
- Your preferred time frame
- The entry and exit criteria
- A trend filter
- Assets to trade
- Your risk management regime
You should keep in mind that most technical analysts will rate any strategy that beats a buy and hold portfolio on the S&P 500 as a success. Such a portfolio returns an average of 10% every year and has a maximum drawdown of 56%. If yours can beat it, you may have something to work with. Ideally, you should look for strategies that beat the S&P by 2-3 times with max drawdowns around 20-35%.
Stay Disciplined
Once you’ve secured a robust trading strategy based on technical analysis, your success hinges heavily on your ability to stay disciplined to the rules of the strategy. The bulk of the railings against technical analysis can be traced to the inability of individuals to stay disciplined to a strategy.
Quitting the strategy in the middle of a drawdown or making changes willy-nilly is an easy way to lose your trading account. Technical analysis doesn’t make any trader immune to losses (neither does fundamental analysis). The success of the approach lies in allowing probability to run its course without interference, trusting the edge you’ve developed.
Is Technical Analysis Better than Fundamental Analysis?
Most savvy traders know not to dwell too long on this debate. They find what works for them and stick to it. For every trader that says that technical analysis is better, another one will strongly support fundamental analysis as the better approach.
In reality, most retail traders are likely to find more success with technical analysis. Like the Turtle Experiment we talked about earlier showed, technical analysis makes it easy for most people to learn how to trade by finding a strategy that works and sticking to it. With technical analysis, all information relevant to an asset is represented on a chart. You can see everything you need to know about price movement in a few glances.
Fundamental analysis requires having deep knowledge of financial principles and the ability to translate any piece of data relevant to an asset as quickly as possible. If you already have this skill, fundamental analysis may just be better for you. This is why this debate has continued to go on for years.
Author’s Recommendations: Top Trading and Investment Resources To Consider
Before concluding this article, I wanted to share few trading and investment resources that I have vetted, with the help of 50+ consistently profitable traders, for you. I am confident that you will greatly benefit in your trading journey by considering one or more of these resources.
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Conclusion
Technical analysis is profitable and effective in the markets. However, success with it heavily relies on how any trader applies it. For technical analysis to work for you, you need to have a trading strategy with a clear edge, sound risk management principles, and the discipline to always stick to your strategy at all times.
If you fail in any of these, technical analysis will not work for you, and indeed, neither will fundamental analysis or any other methods of predicting the market.
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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