Technical analysis is a method of predicting market movements by looking at historical statistical trends. Is it a proven method of analysis or a pseudoscience? Does it work?
Technical analysis is indeed a pseudoscience at its core foundation. While there are countless strategies delivering stable results built around technical analysis, the bulk of the beliefs and practices have not been subjected to peer-reviewed research. The stock market is generally unpredictable.
The rest of this article will look closely at technical analysis and why it is a pseudoscience. We’ll also talk about why it still works even in the face of that fact.
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 Pseudoscience?
By definition, a pseudoscience is any collection of practices and beliefs erroneously regarded as compatible with the scientific method. This means that the practices and beliefs are yet to be subjected to proper scrutiny under a scientific environment.
What Is Technical Analysis About?
In technical analysis, the traders believe that all information around a specific tradable asset is encapsulated in the information displayed on a price chart. Two main assumptions are guiding technical analysis:
- Markets are efficient, and all the factors affecting an instrument are reflected in the price.
- Market price movements are not completely random. Instead, there are identifiable patterns and trends that tend to repeat over time.
So, technical analysts believe that the market encapsulates everything, including market psychology and the fundamentals affecting the asset. Traders only have to analyze price movements to find potential supply and demand areas or the start of new trends in the short, medium, and long term.
This feeds into the belief that an asset’s price is bound to continue or start a trend than move indefinitely in a range. Technical analysts also strongly believe in the past repeating itself in the future.
What Are Common Technical Analysis Tools?
Technical analysts will work with a combination of some or all of the following, melding them into a holistic trading strategy:
- Japanese candlesticks
- Support and resistance levels
- Moving averages
- Oscillators
- Volume and momentum indicators
- Chart patterns
- Trend indicators
Different traders will use various technical analysis tools based on the categories above. Most create unique strategies that feature a few different types of existing technical tools, emphasizing their style of trading. Day traders may work with trend lines and volume indicators to make short-term decisions, while longer-term swing traders may use moving averages or oscillators.
Why Is Technical Analysis a Pseudoscience?
There are a few reasons why technical analysis qualifies as a pseudoscience:
Self-Fulfilling Prophecy
With millions of technical analysts worldwide looking at the same price action and drawing the same inferences, it is no surprise that an asset’s price can pause at certain support and resistance levels or so-called psychological levels. Most of the players in the market expected the pause at that level.
If it happens, it is just a demonstration of the market’s psychology as a whole on a chart and not that the level automatically acted as a “circuit-breaker” on its own. If a large majority of the market doesn’t believe in the strength of a support or resistance level, it won’t hold. This explains why some levels hold while others don’t.
It Is Not Infallible
Technical analysts believe that the price of an asset already reflects all pertinent information about the asset. This is true most of the time. However, there are many occasions where sudden announcements and news releases can affect an asset’s price in the short or long term. For example, methods borne of peer-reviewed scientific approaches will not be influenced by a tweet by a central bank head or a president.
When a doctor carries out a caesarian section, he follows proven methods that have worked for decades and will work (or even get better) in the coming years. On the other hand, the Efficient Market Hypothesis, which is the bedrock of technical analysis, is prone to outside influence from time to time.
Even when no tweet or statement moves the market, technical analysis concepts don’t work all the time. From Bollinger Bands to Parabolic SAR, no technical tools work all the time. This is why the first thing you learn as a technical analyst is to accept losses (within the confines of your strategy). You learn to expect to be wrong once in a while.
Strategies Reflect an Opinion
Most of the technical analysis tools and indicators today are the developers’ opinions on interpreting the market. Traders choose to follow these opinions if they find a way of making it work for them. However, at the core is just a few formulas put together to create some form of direction on a trading chart. In many cases, the proponents of these formulas didn’t use them for trading.
This is why you have multiple interpretations of how to use the same technical indicator, with various traders working with different settings. A scientific fact is proven and universally accepted until proven untrue by higher-quality peer-reviewed work (which will become the global standard). Technical analysis, on the other hand, is highly subjective.
Does This Mean You Should Ditch Technical Analysis? Is Pseudoscience a Bad Thing?
Technical analysis may be a pseudoscience, but it is still highly effective in trading. The alternative is to work with fundamental analysis, but this is a very demanding approach for a retail trader with little or no experience and qualifications in economics and finance. There are far too many variables to account for, making the trading experience a lot more challenging than it should be.
A pseudoscientific topic isn’t a bad thing. There are many other important fields categorized as pseudoscience, but you don’t see people ditching those fields or avoiding them. It is merely a classification. Just like those other fields, technical analysis still has its uses. Instead of ditching technical analysis, you should learn to use it the right way.
What Is the Right Way To Use Technical Analysis?
The first thing to do with technical analysis is to accept it for what it is: a fallible but reliable method predicting market movements. You are playing the odds, knowing that you’ll be right more times than you’re wrong. If you have a quality technical trading strategy with a real edge, you will be right enough times to close most trading years in profit.
Secondly, you should use technical analysis in combination with fundamental analysis where possible. Many traders make the mistake of thinking it has to be an either/or situation, but it doesn’t have to be. The best technical analysts also pay attention to fundamental releases around the asset classes they trade, taking action where necessary.
When you find an interesting fundamental release around an asset, you can use technical analysis to find the best entry and exit points to take advantage of the release in the short to medium term. You’ll always be in the know about the drivers of any move seen on the tradable assets you’re tracking.
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Conclusion
Technical analysis is a highly subjective way of analyzing market movements that contain many beliefs and practices that are not scientifically proven beyond all reasonable doubt. This makes it a pseudoscience. The term in itself is not a slight on the concept.
As many traders have demonstrated over the years, the subjective nature hasn’t made technical analysis less effective. It is indeed a good thing. If technical analysis was a proven science with globally accepted application methods that anyone can use, the financial market as we know it today might cease to exist.
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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