Because technical analysis looks at past prices to predict future moves, you’re probably wondering how that’s possible. So, what are the reasons why technical analysis really works?
Reasons why technical analysis really works include its ability to help spot trends, keep you in a trend, and aid in highlighting trend reversals. Technical analysis can also help you trade in a range, define entries and exits, and choose tools to suit the market.
Now, don’t get the wrong idea and think that you can just pull out a chart and start using technical analysis profitably. Do that, and you’ll likely end up complaining it’s all voodoo. But here are eight reasons why technical analysis really works.
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Table of Contents
8 Reasons Why Technical Analysis Actually Work
Technical Analysis Helps Spot Trends
Even if you’re not involved in the markets, chances are you’ve heard the old adage: the trend is your friend.
Why Trade With the Trend?
This video provides a simple explanation of this concept:
You should trade in the direction of the trend instead of betting against it.
That’s all well and good, but the problem for many people is identifying a trend. You see, markets don’t always trend. Sometimes, they just move sideways.
That’s where technical analysis comes in. It has the tools to help you see when the market’s trending and when it’s ranging.
Using a Moving Average To Identify a Trend
One such tool is the moving average. It makes it easier to see whether a market is in a trend by smoothing out the price action, removing the distracting noise of price fluctuations.
If you see a market making higher lows and higher highs, the temptation is to jump into a trade since the higher lows and highs are one way to define an uptrend.
However, markets that are just going sideways can also make higher lows and highs within their sideways range.
In contrast, a market that’s in a real uptrend will make its higher highs and lows above the moving average. Also, the moving average will slope upwards. In downtrends, it’s the reverse.
The moving average can also help you spot when the market is in a range. In that case, you’ll see the moving average flatten out. That’s useful if you’re a trend-following trader because these strategies may not work in a sideways market.
Technical analysis does really work because it can tell you when a market is trending and when it’s not.
Technical Analysis Can Keep You in a Trend
If the trend is your friend, you want to stay in it as long as possible. Well, technical analysis helps you do that.
It does so through the use of support and resistance. A study conducted in 2000, titled – ‘Support for Resistance: Technical Analysis and Intraday Exchange Rates’, looked at different types of support and resistance levels. It included those that form from peaks and troughs in a trending market. Often, you can highlight them with a trendline joining recent highs and lows.
The study found that support and resistance levels identified by several market players did work. Markets bounced at support and resistance nearly 61% of the time. That was better than levels selected at random.
Based on this study, simple trend lines connecting peaks and troughs do work, helping you stay in a trend for longer.
Technical Analysis Highlights Trend Reversals
If you’re a trend follower, you’ll want to know when the trend is over so that you can exit your trade. And maybe you’ll also want to get into the new trend.
This is another aspect of trading where technical analysis really works.
One way in which you can spot a trend reversal using technical analysis is by using Japanese candlestick charts.
Candlestick charts reveal a lot about the sentiment of market participants. And various candlestick chart patterns can help you spot high-probability trend reversals.
For example, take the piercing line and dark cloud cover candlestick patterns. The first is a bullish pattern you often see at a market bottom. The second is a bearish pattern often seen at market tops.
A 2020 study, titled – ‘The profitability of technical analysis: Evidence from the piercing line and dark cloud cover patterns in the forex market’, confirmed these two patterns provide profitable trading opportunities.
The study tested the patterns using nineteen years of data and twenty-four currencies. It found that these patterns gave a return as high as 642% over the data period.
The patterns work because the way they form highlights changes in investor sentiment significant enough to reverse a trend.
Technical Analysis Can Help You Trade A Range
Markets don’t trend all the time. Often, they fall into a sideways range.
However, that doesn’t mean you can’t trade a sideways market. If you’re a nimble trader, you could trade the up and down mini trends within the range by looking at intraday charts.
But that’s not for everyone. Instead, you can use support and resistance to enter and exit trades. You buy at previous lows in the range and sell at previous highs.
This type of support and resistance was amongst those tested in the 2020 study above. It works because history repeats, as any technical analyst will tell you.
That means buyers will likely step in when a price moves down to an area where buyers have previously bought. Conversely, they’ll sell in an area where they’ve previously sold.
Technical Analysis Can Help Define Entries And Exits
When you trade a market, you need to know:
- Where to get in
- When to get out because your trade isn’t working, and
- When to take profit
Together, these points define your risk/reward when entering a trade. Getting it wrong can affect your profitability.
You’ll recall the 2020 study mentioned above, where researchers found the piercing line and dark cloud cover patterns did work. However, profitability depended on the choice of risk/reward.
When researchers used a 1:1 risk/reward, the patterns failed to provide positive returns. But when they used risk/reward ratios of 2:1 or 3:1, the patterns showed significant positive returns.
Technical analysis works here because it gives you a clear visual of where to set entries and exits.
Trading the Dark Cloud Cover
Let’s look at trading the dark cloud cover pattern using technical analysis as an example. For that pattern, a sensible entry point is the bearish candle’s close or low. A natural place to stop your trade out is above the high of the bearish candle. After all, if the market has turned bearish, that high should hold.
There’s an explanation of this in the following video:
Finding a Profitable Exit
You can also look to the chart to find a profitable exit, remembering you want at least a 2:1 risk/reward to be profitable over time. So, look to take profit at a support area that gives you that risk/reward.
If the price support is too close to your entry point, so you can’t get a 2:1 risk/reward, you probably shouldn’t take the trade.
Helping you to set entries and exits to trade profitably is another reason why technical analysis works.
Technical Analysis Has Tools To Suit All Market Conditions
One mistake that people make with technical analysis is to assume that one size fits all. However, with so many different instruments available to trade, such an assumption can prove costly.
For example, a 2016 study, titled – ‘Technical Trading: Is it Still Beating the Foreign Exchange Market?’, looked at various technical analysis tools, including moving averages. It backtested the profitability of the tools on thirty currencies using forty-five years of data.
It found that different technical analysis tools worked in different markets.
The variety of tools technical analysis offers makes it flexible. So, with proper backtesting, you’re bound to find one that works in your chosen market.
Technical Analysis Settings Are Adjustable
Just as the tools that work in each market may differ, so do each tool’s settings.
We can see this from the 2016 study above. It used 12,780 different settings for the moving averages.
It found that not all of them worked, and amongst the settings that did, they worked to varying degrees, depending on the market.
Because one size doesn’t fit all, the ability to adjust technical analysis settings is another reason why technical analysis really works.
The Pros Use Technical Analysis
This isn’t really a reason why technical analysis works, but more a confirmation that it does.
You might have the impression that technical analysis is the preserve of retailer traders. Indeed, it is popular in that sphere, but the pros also use it.
For example, some algorithmic trading uses technical analysis. It’s also used by a majority of fund managers worldwide, according to a 2010 study, titled – ‘The use of technical analysis by fund managers: International evidence’. Also, another 2014 study, titled – ‘Sentiment and the Effectiveness of Technical Analysis: Evidence from the Hedge Fund Industry’, revealed that hedge funds use technical analysis.
When Does Technical Analysis Work?
Technical analysis works when you use it properly.
As you’ve seen above, technical analysis works in both trending and range-bound markets. However, you need to select the right tools for each, so don’t trade a range-bound market with trend-following indicators.
Also, make sure you backtest your rules and settings.
You need to manage risk and ensure you have a decent risk/reward ratio before you trade. The evidence shows that you can get good signals but still lose if your risk/reward isn’t right.
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Conclusion
There you have it: eight reasons why technical analysis really works.
It all boils down to the ability to adjust technical analysis tools and settings to suit different markets.
Its tools that enable traders to spot and ride market trends are another reason why it works. Yet, it’s also effective in sideways markets because of its principles of support and resistance.
Just as important, technical analysis can help with risk management, so it helps you set entry and exit points to produce profitable trades or minimize losses.
And that, after all, is the name of the trading game.
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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