Technical analysis: true or false?

What is Technical Analysis?

Technical analysis involves analyzing the market to predict the direction of prices based on past market data. It employs trading rules and models based on volume and price transformations, such as moving averages, relative strength index, inter-market, regressions, business cycles, and more. In simpler terms, technical analysis is the prediction of the direction of the prices based on chart patterns.

The approach is guided by three major assumptions: market action discounts everything, prices follow certain trends, and that history repeats itself. While the use of technical analysis has increased significantly over the years, scientific literature provides differing views on its effectiveness in trading.

Criticism of Technical Analysis

Most people offer just one simple criticism: it's humbug. Period.

Among the major scientific criticisms of technical analysis though is the Efficient Market Hypothesis. The hypothesis states that it is impossible to consistently achieve returns superior to the return on the market based on a risk adjustment using publicly available information. This implies that technical analysis is not always an effective way of predicting prices and trading for superior returns. Although the validity of this hypothesis has been questioned in the past, it contributes greatly to scientific analysis of the effectiveness of technical analysis.

In the investment community, a wide variety of technical indicators and multiple styles of charts are used to analyze price movements. One of the most commonly used styles is Japanese Candlestick Charts. Scientific analysis of these charts also questions their effectiveness in forecasting market prices.

Effectiveness of Japanese Candlestick Charts

The Japanese Candlestick technique involves plotting of past price action using high, open, low, and close prices. The technique is used for various underlying assets including commodities, index, and stocks because the candlesticks create patterns that can be quickly interpreted.

Many traders also claim these patterns can be used to forecast future price movement. However, evidence about the effectiveness of candlestick technique over a larger number of occurrences is still scarce.

In research conducted by Jamaloodeen, Heinz, and Pollacia (2018), it was found that the Hammer and Shooting Star patterns on the candlesticks offer little forecasting reliability when using closing prices. However, the shooting star is reliable when using high price while Hammer is reliable with low price.

Jamaloodeen, Heinz, and Pollacia study further revealed that the use of Shooting Start to determine a temporary top had no better pattern’s reliability than the use of a randomly chosen candle. In contrast, using Shooting Star’s high price as a temporary top had better predictive power than a randomly chosen candle.

When the hammer pattern was used, similar results were observed. If the Hammer’ closing prices was used as a temporary bottom, its predictive power was the same as that of a randomly chosen candle. On the contrary, selecting the Hammer’s low price again had a better pattern’s reliability than a randomly selected candle.

Previous scientific studies indicate positive results when using candlesticks, but for limited markets and patterns. For instance, the Bullish Harami, Bullish Engulfing, and the Piercing are more reliable in predicting the Taiwan stock market. On the other hand, the cross signals and Bearish Harami are effective in Chinese exchanges.

The Piercing, Engulfing, and Bullish Harami patterns also work well with stocks of lightly liquid and small companies. When using S&P data, candlestick provides predictive power based on market past performance. Still, candlestick add no value to trading certain stocks and commodities. For instance, their predictive power does not work on the Brazilian market or when using certain methods like the buy-and-hold.

Effectiveness of Technical Analysis in Trading

For short-term exchange rate forecasting, traders usually rely on the support and resistant levels. These are the points at which the prices may be interrupted and reversed. However, the ability to predict whether intraday trend will be interrupted at these levels is yet to be properly evaluated.

In a research conducted by Osler (2000), it was revealed that support and resistance levels help to predict interruptions intraday trend. However, the predictive power of these levels tends to vary across firms and exchange rates.

Smith and others (2015) also conducted a study on the use of technical analysis in trading. Their focus was on different sentiment environments, specifically on astute and sophisticated traders like hedge fund managers. Their finding indicated that technical analysis is more useful during high-sentiment periods that have larger mis-pricing. Such periods cannot be exploited fully by arbitrage activities because if short-sale impediments. Hedge funds that use technical analysis during this period demonstrate lower risk, higher performance, and superior market-timing abilities.

Concluding remarks

Technical analysis involves studying price patterns in the market before making a tradition decision. Although many patterns are available for studying prices, traders usually choose between chart patterns, candlesticks, and indicators.

The technique can work with some markets and commodities. However, it may often fail because financial markets are influenced and impacted by several factors, not simply due to a pattern.

While factors like support and resistance levels can help in determining price movements, the pattern may also be influenced by factors beyond technical analysis.

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