While traders have varying priorities depending on their time-horizon and capital allocation requirements, the topic of technical analysis and whether it actually works has been fiercely debated among crypto enthusiasts and traders alike.
How Does Technical Analysis Work?
Technical analysis (also known as charting or ‘TA’) is defined as the use of patterns in price action to identify trends and make predictions. As the saying goes, ‘history doesn’t repeat itself but it often rhymes’; and technical indicators try to take advantage of this to predict the future price of an asset.
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Technical analysts or ‘chartists’ believe that fluctuations in the price of an asset conveys a stream of never-ending information and that markets tend to move in trends (which can be short-term, medium-term and long-term). Traders can capitalise on how the price has acted in the past to give an indication of its future behaviour by plotting trendlines, support and resistance levels and measuring momentum and volume.
Why Are Some Traders Convinced Technical Analysis is Useful?
There can be enormous differences in capital allocation and appetite for risk among traders. But in terms of execution, TA in its perfection means nothing if the trader disregards risk management and position sizing. The main reasons put forward in favour of TA are:
- OHLC, Volume and Other Indicators are Objective
Advocates of TA highlight that the open-high-low-close price (known as OHLC) and volume of an asset are objective figures that traders can base their decisions on.
Both OHLC and volume are unambiguous in the signals they provide, where rising volume is followed by a change in price. A closing price further from the opening price indicates that buyers or sellers have dominance. Conversely, if the opening and closing prices are close together, it usually indicate indecision amongst market participants.
- TA Can Improve Trading Performance and Remove Behavioural Biases
There are various research articles that suggest using TA can improve trading performance. For example, one study which appeared in SpringerPlus, found that using TA can help counter behavioural biases, where traders tend to sell winning stocks too soon and hold on to losing stocks for too long. The article looked at strategies employing the MACD indicator and found that they outperformed ‘buy and hold’ strategies for Asian stocks.
- 200-day moving average (Self-fulfilling Prophecy)
Another good example of why TA is purported to work is exemplified by the 200-day moving average. Individual traders, as well as big institutions, watch the 200-day moving average to evaluate the market’s direction.
Most traders in the market expect it to work, making it a useful indicator. Therefore, these expectations become a self-fulfilling prophecy, where traders following similar systems will converge on a particular belief, which then plays out in the market.
What do the Critics Say About Technical Analysis?
- TA Involves Extrapolation and Human Error
Extrapolating results based on TA strategies is unlikely to be a good representation of your future performance. The nature of the market may change over time and TA strategies may become ineffective under certain conditions. Another factor that makes TA ineffective is the human aspect of implementing these strategies. While some TA indicators may be profitable, they require the execution by the trader.
- TA Can Often be Subjective
There are so many trading indicators, combinations and variations in settings, that an individual could choose from any two indicators and they could give conflicting suggestions. Therefore, confirmation bias could be present when traders chart with their favourite indicator. Some behavioural analysts maintain that, whether consciously or subconsciously, traders choose charts that confirm their prior beliefs.
Not everyone is using indicators in the exact same way and will optimise them differently. The variety and combinations of different indicators mean that charts are interpreted subjectively by traders, so different individuals may disagree on a chart pattern or some other signal.
One reason TA is often misunderstood is that there is a lot of inconsistency among different technical strategies. For instance, the motto “buy low, sell high” conflicts with the common advice that “the trend is your friend”.
If you buy low, you are likely to be buying into a dip and if you sell high, you are likely to be selling amid an upward trend. Critics of technical analysis would, therefore, argue that much of its approach to trading is practically worthless and just contributes to noise in the markets.
- Fundamental Analysis is Key
Fundamental analysis doesn’t study price action but looks at the factors impacting demand and supply for an asset. While exact entry points or stop losses are not informed by a fundamental approach, some investors prefer to analyse the markets in this way to cut out the noise associated with technical indicators.
The signals that technical indicators provide generally don’t last that long, whereas a fundamental theme could propel a move in the markets for months or even years. The fundamental school of thought says that the price does not reflect all available information and hence there may be some fundamental factors that are not accounted for.
For example, suppose a perfectly formed chart pattern suggested a bullish move. All it takes is one piece of bad news or a major demand shock to rattle the confidence of traders and the price action may do the opposite of what you’d expected from the chart pattern.
In Summary: Be prepared for the unexpected
Most traders utilise some combination of fundamental analysis and technical analysis. Ultimately, the method chosen will be determined by multiple factors, including risk appetite, asset selection and capital allocation.
But as demonstrated by the various breaches of cryptocurrency exchanges and shocks caused by regulatory announcements over the years, some events will ultimately catch some investors off-guard, regardless of how rigorous their technical or fundamental analysis has been.
Nevertheless, technical analysis can prove a worthy approach to understanding market forces even if it may not be enough to prepare for all external factors that may erupt from time to time. In that light, it may be best to complement technical analysis with a more holistic understanding of wider market dynamics, while keeping up to date with market news and movements.
About Charles Phan:
Charles Phan is the Chief Technology Officer at Interdax, the all-in-one cryptocurrency exchange providing a safe, secure, and more efficient platform to the masses through innovative derivatives contracts. Oxford graduate and quant trader, Charles was partner in two hedge funds and worked at prop trading firms where he built ultra-low latency trading systems and quant strategies. At Interdax he coordinates the engineering efforts.