Before we spend a whole chapter on technical analysis, it is important

to ask an essential question: Does technical analysis work?

There is a ton of research on technical analysis out there, but unfortunately
no conclusive evidence. There is some modest evidence of
persistent trend and tradable patterns in certain markets over time
but it is unclear how much of this works in real time. (It could just
be hindsight and data snooping.) Trend-following models in FX
have performed poorly since the 1990s and the evidence generally
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suggests that some patterns worked for some periods but profitable
technical patterns are arbitraged away over time.
One study of all the literature around technical analysis1 concluded
the following:
Early studies indicated that technical trading strategies
were profitable in foreign exchange markets and futures
markets, but not in stock markets before the 1980s.
Modern studies indicated that technical trading strategies
consistently generated economic profits in a variety
of speculative markets at least until the early 1990s.
Among a total of 92 modern studies, 58 studies found
positive results regarding technical trading strategies,
while 24 studies obtained negative results. Ten studies
indicated mixed results. Despite the positive evidence on
the profitability of technical trading strategies, it appears
that most empirical studies are subject to various problems
in their testing procedures, e.g., data snooping, ex
post selection of trading rules or search technologies,
and difficulties in estimation of risk and transaction
costs. Future research must address these deficiencies in
testing in order to provide conclusive evidence on the
profitability of technical trading strategies.
A study by three professors at MIT2 concluded:
By comparing the unconditional empirical distribution
of daily stock returns to the conditional
distribution�conditioned on specific technical indicators
such as head-and-shoulders or double-bottoms�we find
that over the 31-year sample period, several technical
indicators do provide incremental information and may
have some practical value.
So there is some evidence that it works, but also plenty of studies
showing it does not. Another study3 came to this conclusion:
Over 5,000 popular technical trading rules are not consistently
profitable in the 49 country indices that comprise
the Morgan Stanley Capital Index once data snooping
1http://chesler.us/resources/academia/AgMAS04_04.pdf.
2http://web.mit.edu/people/wangj/pap/LoMamayskyWang00.pdf.
3https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1181367.
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bias is accounted for. Each market has some rules that are
profitable when considered in isolation but these profits
are not statistically significant after data snooping bias
adjustment.
Some people think technical analysis is useless�a complete
joke. Other traders think technical analysis is the only tool you
need to trade successfully. My philosophy on technical analysis is
somewhere in the middle.
I think technical analysis is a valuable tool but it does not work
well as a standalone trade selection or forecasting methodology. The
more years I trade, the more strongly I believe that technical analysis
should be used as a tactical and risk-management tool and not
as a trade selection tool. This comes from years of trading experience,
from watching many people trade, and from reading volumes
of research on the topic.
While I am sure there are examples out there somewhere, in more
than 20 years of trading on both the buy side and the sell side, I have
never worked with a purely technical trader who made meaningful
P&L. Every successful trader I have worked with over the years
either trades macro or uses a multifactor approach. And I have seen
many traders who use only technical analysis fail miserably. Think
of the most successful traders of all time: Soros, Tudor-Jones, Bacon,
Druckenmiller. They are macro or hybrid guys, not pure technicians.
They supplement their analysis with charts but their ideas come from
all over the place.
Most technicians I�ve seen or worked with always think they are
just one tweak away from perfecting their model but can�t ever quite
produce the profits they just know their system should deliver. There
is an entire industry devoted to selling technical analysis tools and
systems of questionable (or negative) value. So healthy skepticism is
warranted.
Do you really think it passes the commonsense sniff test that you
can just look at a chart, see a simple pattern, trade it, and consistently
make money? Given the thousands of traders and billions of lines of
code you are competing with, probably not. There were systematic
funds that profited from simple technical analysis in the 1980s and
1990s, but those days are long gone. Systematic funds now compete
on a much more complex playing field and the profitability of
simple trend following and other technical systems has converged
toward zero.
While it is hard to assess the forecasting value of technical analysis,
there is another simple reason that using technical analysis is inherently
risky (assuming you are a human being). Humans are designed
to see patterns. It�s how our biology works. It allows us to simplify