This is why you should use technical analysis
Why technical analysis can not only be helpful for trade entry, exit and stop loss placement but also for risk management purposes.
Unlike economists or those investors who purely look at fundamental, macro-economic data such as central bank, monetary and fiscal policy, Gross Domestic Product (GDP), inflation, retail sales and the like, technical analysts focus on market price, volume and sentiment.
In the words of the, among technical analysts, well-known John Murphy technical analysis is the “study of past price action, primarily through the use of charts, for the purpose of predicting future price trends in the markets.”
Unlike their fundamental counterparts who, when analysing equities, for example, look at a company’s management, business model, financial, ratio and valuation analysis etc., technical analysts do not seek to establish the ‘value’ of a security but instead study the effects on the price of that security produced by the activities of market participants.
Technical analysis is about studying the ‘price’ of an asset in order to gauge whether it is evolving in a trend and whether this trend is likely to continue or not, regardless of its ‘fair value.’
Technical analysts thus do not believe in the efficient market hypothesis which states that asset prices reflect all available information; a direct implication being that it is impossible to ‘outperform’ the market consistently on a risk-adjusted basis since market prices should only react to new information.
According to the UK Society of Technical Analysts (STA) “a basic premise of the technical approach is that market action discounts everything: all that is known, or can be known, is ‘in the price’.” In other words, the current supply/demand situation, i.e. the ‘price’ of an asset, has already taken all known information into account. Anything that can affect the price, be it fundamental, political, psychological or otherwise, is reflected in the price.
Another of the core tenets of technical analysis is that financial markets reflect human behaviour, and that history repeats itself or at least rhymes since emotions like greed, hope and fear, for example, have been driving markets since the beginning of time. This is because human beings are not always rational as economic theory has us believe and instead have biases and other limitations.
Even in the day and age of algorithmic, quantitative and high frequency trading the above still holds true since their models tend to be based on past price action which in turn has been, and continues to be, influenced by humans trading and thus by mass psychology.
Therefore, by analysing the price of an asset and its derivates, such as technical indicators and oscillators, volume and sentiment - essentially measuring how bullish or bearish investors are - technical analysts can make better forecasts with regards to the future direction of an asset’s price than fundamental analysts can, especially in shorter-term time frames such as days, weeks and months.1
This is because fundamental analysts deal with a plethora of variables such as monetary and fiscal policy, inflation etc. to name but a few and with data which are delayed, often published every month or quarter, and often get revised, making an economist’s job anything but easy. Furthermore, they can be duped by fraudulent data as was the case with the German company Wirecard and the US based crypto exchange FTX.
Since technical analysts primarily hone in on just one variable – price - the possibility of getting their forecasts right tends to be greater, provided that they know what they are doing, have been properly trained and have extensive financial market experience.
Even when companies go bust, irrespective of whether they publish fraudulent data or not, their share prices most of the time tend to reflect that and are already trading in downtrends, something a technical analyst can spot.
According to the STA, “a wide range of techniques may be applied to the assessment of price action, including the study of repetitive patterns on charts, mathematical calculations to determine the speed and momentum of a move, and statistical tools to identify extreme conditions”, all of which fundamental analysis alone cannot do or can only do after the data have confirmed a change in direction.
At the end of the day, both fundamental and technical analysis deal with demand and supply and hence ‘price’ as well as with future price direction and targets. However, especially for shorter-term and intraday trading technical analysis clearly seems to have the edge as it can also be used for specific, price based, stop loss and thus risk management.
1 discussion paper No. 12-026 “Exchange Rate Expectations of Chartists and Fundamentalists” by Christian D. Dick and Lukas Menkhoff (March 28, 2012)
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