Why Technical Analysis Works

Technical analysis is one of the most widely used trading tools on Wall Street, but it is also one of the most controversial. Technical traders swear by it, while fundamental traders often look down on it as illogical and ineffective.

The following is a look at what technical analysis is — and why the truth is somewhere in the middle.

What Is Technical Analysis?

Traders and investors are typically broken down into one of two camps. Fundamental traders buy and sell stocks based on the financial metrics of the underlying company. They attempt to determine value based on metrics such as earnings, revenue, subscriber growth and debt, and then look for stocks that are undervalued in the market.

Technical traders don’t care anything about the underlying company. Instead, technical traders look only to a stock’s chart to analyze its past price action and attempt to predict what will happen next. Technical traders rely on price patterns, trends and signals to identify when to buy and sell stocks.

Why It Works

The idea that a certain pattern in the chart of a stock has any impact on whether traders will buy or sell that stock may seem counterintuitive. Yet investors who dismiss technical analysis may simply be looking at it the wrong way.

Patterns in charts don’t necessarily dictate the decision-making of traders: instead, they are a visual representation of market psychology.

Take the popular bearish head-and-shoulders formation. The pattern is typically formed at a market top after a long rally. At first glance, it may seem like an arbitrary pattern in the shape of a person’s bust. Upon closer look, a head-and-shoulders formation is actually a visual representation of a shift in market thinking during a transition from a bullish trend to a bearish one.

A bullish trend is marked by a stock making a series of higher highs and higher lows, producing a staircase-like pattern. When the bullish trend ends, buying volume at the highest price is exhausted. The next time the stock rallies in an attempt to make a higher high, it doesn’t even make it back to the previous high before it is met with selling pressure.

As a result, the stock begins to make its way down a descending staircase and forms a head-and-shoulders pattern.

In this case, the head-and-shoulders pattern is not predicting where the stock is headed. It is rather a visual representation of a shift in buying and selling demand. Technical traders often use these types of signals to inform their trading decisions. No magic or voodoo required.

Self-Fulfilling Success? 

Another part of technical analysis that makes it somewhat less reliable is its subjective nature. While there are widely accepted general approaches to technical analysis, the details of the strategies can be tweaked and adjusted in nearly limitless ways. As a result, it’s often easy to obtain differing and even contradictory signals from the same chart, depending on the time frame and method of analysis used. 

In addition, considering how popular technical analysis is on Wall Street, a certain amount of its success may simply be self-fulfilling. For example, the cross of the 50-day simple moving average above the 200-day simple moving average is a bullish signal known as the golden cross.

If enough technical traders see a golden cross as a bullish signal, they will buy the stock. If Wall Street trading algorithms see an increase in buying volume, they may also buy the stock. As a result, shares trade higher not necessarily because of the golden cross, but because of how it's interpreted by traders. 

Takeaway

In reality, it’s difficult to prove or disprove the effectiveness of technical analysis given its subjective nature.

Regardless of whether you rely on fundamentals or technicals, there is one piece of advice that almost any decent trader would give: the more factors informing a trade, the better. Stock trading is an art, not a science.

If there were a proven system that works every single time, there would be a lot more billionaires in the world. Successful trading is about probabilities and risk management, and most successful traders take into consideration a wide range of technical and fundamental factors before making the decision to buy or sell a stock.

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