Does Technical Analysis Work?

Does Technical Analysis Work

Technical Analysis is a method of analyzing and evaluating securities from the statistics generated by market activity alone. Hence seasoned technical analysts can predict the movement of a stock even without knowing its name or sector.

In Technical Analysis, the Dow Theory is the most tested theory apart from the fact that it is so simple in its application, that even a newcomer can apply it. The Dow theory was tested against buy-and-hold strategy for the period 1929-1998 on the Dow Jones Industrial Index. When the system identified the primary trend as bullish, a long position was initiated in a hypothetical index fund. When the system signalled a bearish primary trend, stocks were sold and the money was placed in fixed income instruments. The Dow Theory outperformed the buy-and-hold strategy by about 2% per year. If compared to risk-adjusted returns, the margin of out-performance would increase.

Again, over the past 18 years, the Dow Theory has under-performed the market by about 2.6% per year! However, when adjusted for risk, the Dow Theory was again seen to be outperforming the Buy-and-Hold, albeit marginally.

However, most people forget to note that a simple 100-year-old technical analysis method – the Dow Theory worked as a stand-alone tool to invest! This is the biggest proof that Technical Analysis works. The Dow Theory was found to be slightly under-performing during bull markets but outperforming during bear markets. But by taking money out of stocks after bear signals, the risk (volatility) of the portfolio was significantly reduced.

Dow Theory is only concerned with the trend. It does not use any fancy indicators and jargon. An investor can shut out all the information and invest only based on the Dow Theory. It is extremely simple to apply and does not need extreme data crunching like Fundamental Analysis.

Stock performance is always measured by comparing its current market price against the entry. The entry prices are always past prices. Any trader or investors' entry prices highly influence the eventual decisions to close their positions (or buy more). Therefore, it is too naive to believe that past prices don’t have an impact on how a stock trades in the future.

When the legendary Japanese businessman Munehisa Homma made a fortune in rice trading, it too was due to the basic nature of supply and demand which Candlestick analysis show better than many other tools.

Edward Seykota, a top commodities trader, pioneered Systems Trading by using early punched card computers to test ideas on trading the markets, in 1970. His success was attributed to the development and utilization of trading systems which he first tested on a mainframe IBM computer. He developed his first trading system on exponential moving averages. Later, the brokerage house he had been working for, adopted his system for their trades.

Later the Turtle Experiment in 1983 proved that anyone could be taught to trade. Richard Dennis, just to prove an argument, recruited and trained some novice traders in trend following and also funded them with real money to trade. These novices amassed an aggregate profit of over $100 million dollars over 4 years. The Turtles experiment is considered one of the most famous experiments in trading history.

In a broad-based study examining 10,000 actively managed funds in the US during two decades, authors David Smith, Christophe Faugère, and Ying Wang found that, Fund managers and Institutional Portfolio Managers who employed Technical analysis, which relies on the study of price and volume data to predict the trend of stocks and other financial instruments, delivered higher returns than those who did not.

In fact, there are several shining examples of highly successful traders like Marty Schwartz, Mark D. Cook, Victor Sperandeo, Ed Seykota, James Simons, Ray Dalio, Steven Cohen and Paul Tudor Jones II, who primarily use technical analysis in their trading decisions.

Chart analysis is done to establish the probability of trend change and to set price targets and objectives and much more. It is believed that by just positioning yourself in the direction of the dominant trend, one can make money. And there is no better tool than technical analysis to sniff out the trend.

Methods of technical analysis generate useful information, which is used for uncovering and organizing facts about market behaviour. It increases the investor’s understanding of the markets and how it moves and helps devise strategies to exploit this market behavior. It plays an invaluable role in the financial success of any active investor or trader.