Why Technical Analysis is Controversial (and How to Use it Properly)

Technical Analysis is one of those topics that divides a lot of people in the #trading community--some people love it, and some people hate it.

In this article, we show why #TechnicalAnalysis is so controversial, and what is the most productive way to understand technical analysis, and how to use it properly.

**This article is adapted from a series of lectures from my Coffee Trader's Course.**

Why Its Controversial

One of the biggest complaints against technical analysis is the lack of scientific evidence, but we will see that there is plenty of scientific evidence available, but also how this is not straightforward.

The controversy of technical analysis begins with the name. The name “technical analysis” implies that this is some kind of science with hard and fast rules and correct answers.

So what is technical analysis, and what is the evidence for it?

Technical analysis is a discipline that looks entirely at price action itself (and to a lesser extent, other trading data like volume and volatility), for signals on how to trade profitably.

The core thesis of technical analysis is that prices tend to move in “trends” that continue in one direction for a period of time. Therefore, the goal is to identify when a trend has started or is about to start.

Modern Technical Analysis can mostly fall into 1 of 3 categories:

1) Chart Patterns

2) Moving Averages

3) Technical Studies

We will elaborate on these in subsequent articles, however, I want to highlight that looking at price action to predict the direction of price is an old idea that predates modern charting software.

Famed, early 20th century stock trader Jesse Livermore had a system for “reading the tape” (a printed paper-tape of stock prices), Ralph Nelson Elliot invented Elliot Wave in the 1940s, and Charles Dow developed Dow Theory in the late 19th century and early 20th century.

Japanese Candlestick charts are purportedly much older, and my own research into 18th century rice futures trader, Honma Munehisa has confirmed his observations on trends.

However, the fact that a discipline is old does not mean that it is scientifically valid. Astrology and Tarot Card reading are thousands of years old and persisted into the present but have been shown conclusively to be ineffective in predicting the future.

The criticisms against technical analysis are several but here are some of the strongest:

1) Self-defeating prophecy: the more successful a system is, the more its value will decline. Volume tends to increase slippage, so if everyone trades a signal at the same time the value will diminish for the participants.

2) Ambiguity of chart patterns: Chart patterns often lack clear, objective rules for what a chart pattern purports to show. Is this a “rounded bottom” reversal or a “cup and saucer” continuation pattern?

3) Lack of convincing theoretical explanations: How does a “cup and saucer” pattern in prices show that a trend is going to continue?

On top of all of these, there is the problem of evidence. Here is a recent informal study from a few years ago that found significant negative correlations with technical indicators. In other words, using technical analysis had statistically significant record of losing money (the exception? Bitcoin of course).

One of the biggest problems with Technical Analysis is that you can only test it in the past.

Wait, isn’t all available data, past data? Yes, but the problem with a trading system is that it influences the market.

This is the fundamental problem of backtesting.

Backtesting is when you come up with a trading system, and then use historical price data to see how well your strategy would have worked. Backtesting is a great tool to evaluate systems but it is limited by the fact that it cannot account for the impact of your strategy itself on the market.

Every time you buy #stocks, or #futures in a liquid market, you raise the price of that security. This impact is magnified the faster you put on your trade, and the more volume that you put on.

For example, if you buy 1,000 lots of coffee futures all at once you will have a massive impact on price: you might raise prices by 10-20c...maybe more if it was a less liquid market or time of day.

If the price of coffee spikes from your massive buy, that will influence other traders in the market who will maybe take this as a signal that prices are overvalued and will sell, or perhaps take it as a signal that the trend is bullish and buy. We don’t know how they will react.

However, we do know that this can set off a chain reaction that will influence how prices unfold.

Contrast this with testing a weather forecast model.

If we test a weather prediction system that evaluates past weather patterns and predicts weather in the future, we can evaluate those systems in the present, to see how well they compare to our models.

The fact that we are predicting higher or lower temperatures, faster or slower winds, or the quantity of rainfall, does not influence those systems themselves in any material way. Therefore, we can assume that the conclusions are much more robust than we could glean from backtesting financial strategies.

Evidence in Favor of Technical Analysis

That said, there is a decent amount of academic literature supporting the idea that technical analysis and technical trading systems do work.

One of the first academic papers that I came across that studied technical analysis was a 2003 paper, “How rewarding is technical analysis? Evidence from Singapore stock market” by Wong, Manzur and Chew. This paper studied several quantifiable technical analysis strategies and concluded that they would have been profitable (although they suffer the above problem of #backtesting).

There are other more recent papers, such as “Technical Analysis and Discrete False Discovery Rate: Evidence from MSCI Indices” by Sermpinis, Hassanniakalager, Stasinakis and Psaradellis, published in 2019.

There is also plentiful anecdotal evidence from successful traders like Paul Tudor Jones, and the Trend-Following “Turtle” traders who learned a trading system and then went on to become successful #hedgefund managers.

In my own experience trading prop, my most profitable strategies were simple moving average #tradingsystems in the #coffeemarkets.

So if it is at least theoretically possible that Technical Analysis can work, then how should we think about it, and how can we trade it profitably?

The Proper Framework

My observation on technical analysis is that it is really a subset of #CrowdPsychology, and that Tech Analysis can be both understood and successfully traded upon.

Crowd Psychology is a subset of social psychology that traces its origins to the late 19th century, and is intimately connected to financial markets. Two books are pivotal here: “Extraordinary Popular Delusions and the Madness of Crowds” by Charles Mackay (published 1841) and “The Crowd” by Gustave Le Bon (published 1895).

These two books both recount various instances of manias and delusions shared by multitudes of people concurrently. These include obsessions with witchcraft, pseudo-sciences like alchemy and astrology, as well as more