What’s the real deal with Technical Analysis? Can you really use it to make trading returns on a consistent basis?

Indeed, this is an ago old question which long predates cryptocurrency trading. Some traders will swear by it while others view it as nothing more than financial tarot card reading.

As with most things related to trading, the answer to this question usually comes down to the individual trader and the assets being traded. It is not just whether it is used but how it is used.

In this post, we will take a deeper look into technical analysis theory and whether it can effectively be used in your cryptocurrency portfolio.

But first, let’s start with some basics…

What is Technical Analysis?
Technical analysis is quite broadly defined as the practice using past price information on a particular asset in order to make forecasts as to the future direction of said asset.

Unlike fundamental analysis that analyses the underlying asset itself, technical analysis is merely concerned with the price levels, trends and volume. It is a theoretical expansion of the notion of behavioral economics.

They believe that price trends tend to repeat themselves due to the collective behavior of these investors. Technicians base their analysis on crowd psychology and the patterned behavior of the investors. Given that technical analysis is purely concerned with price data, it can be used to map the price of any asset over any period of time. Hence, they have been used in broad range of asset classes with analysis stretching from years to mere hours.

While this is the textbook definition of what technical analysis is, many technicians know that it should not be looked at as an exact science. They view it as a strategy that can inform their trading and increase their chances of long-term success.

Now that you have a reasonable idea of what technical analysis is, let’s take a look at the other side of the argument.

Arguments Against Technical Analysis
One of the most quoted arguments against the significance of technical analysis is that of the Efficient Market Hypothesis (EMH). This basically asserts that asset prices fully reflect all available information and that price movements follow what is called a “Random Walk”.

In other words, the asset price will reflect all available information in the market and is correctly priced. If there are movements in one way or the other, these will be related to pure chance and cannot be modeled or predicted.

Of course, the EMH is itself quite a dogmatic theory that is often also used to dismiss other forms of investing such as fundamental analysis. In its strictest form, the EMH asserts that the most optimal investing strategy is to “buy and hold” the market as any other form of active management cannot yield excess returns in the long run.

While most people will avoid this rigid approach when countering technical analysis, these are some of the other arguments that are made:

Subjective Pattern Interpretation: When the technician is trying to identify charts and patterns in the price of an asset, it is possible for them to “see” a pattern when it is really subjective. In other words, it is possible that one technical analyst will identify a head and shoulders pattern when others are not likely to see it. So the effectiveness of a trading strategy based on subjective interpretation is hard to assess.
Data Mining Bias: This is when a technical analyst will select one indicator over the other given that this indicator confirms their view of where the market is going. Even if that indicator is contradicted by a whole host of other technical indicators.
Stronger Competition: Even if there are cases when past price information informs future prices, technicians have some pretty stiff competition from the likes of quantitative hedge funds and high frequency trading firms. These firms use complicated AI algorithmic trading strategies that are able to read order flow and movements much more quickly than the average technical analyst can.
Indeed, some of the most notable investors such as Warren Buffet do not view technical analysis too favorably. He famously once said:

I realized that technical analysis didn’t work when I turned the chart upside down and didn’t get a different answer

So, do these arguments have any basis in fact?

Lovely, can you finish it

So, do these arguments have any basis in fact?

Countering the Critics
These arguments against technical analysis tend to miss the mark in a number of ways. This is because they assume that those who practice technical analysis view it as some sort of a divine text that cannot be questioned.

The vast majority of technicians use it as a basis to inform their opinion and manage risks. They do not operate in a silo without consideration of other factors that could drive the price of the asset.

Let’s take a closer look at some of the above arguments and how they can easily be refuted:

Efficient Market Hypothesis:

This is exactly what the name suggests it is, a hypothesis. It is based on a mathematical theory that markets are always rational and that there are never any mispricings. There have been countless studies and empirical research that can refute this hypothesis.

For example, studies such as those done by Jegadeesh & Titman have shown the statistical significance of momentum-based trading strategies. There have been a number of other studies that have shown the same statistical significance in other markets.

Momentum Strategy Performance
Cumulative Performance of a Momentum Based Strategy. Source: Upenn
Momentum studies are used regularly in technical analysis and they clearly show that past returns are related to the future returns.

Pattern Interpretation

Yes, it is possible that a technician is noticing a pattern that is entirely subjective, however this argument makes a generalization. It assumes that all technical analysts lack discipline and will “reason” their way into recognizing and confirming a pattern.

Disciplined technical analysts will have clear mental guidelines and rules of thumbs that they will use when identifying the exact patterns and formations. Getting the setup right is essential and a weak pattern is likely to be a less instructive sign for the technical analyst.

Data Mining Bias

This also depends on the professionalism of the technical analyst. Very few technicians will use only one or two indicators. They will try and combine a number of them in order to confirm the signals certain indicators are giving.

If they have contradictory readings from one or the other then they are likely to do more research instead of choosing the only indicator that confirms their view.

Moreover, the skilled technical analyst will also borrow studies from other disciplines in order to confirm their view. Traders should never operate in a vacuum and be hostile to other analysis and methods

Stronger Competition

This argument is actually irrelevant to the broader question.

So what if a large sophisticated hedge fund is able to get better returns than you? That is not the underlying question. All that matters is whether technical analysis is able to provide you with the right tools and indicators to get better returns than you would if you did not use it.

Whether the High Frequency trader can get better levels and faster execution should be irrelevant to your decision of whether you should use it. Their systems costs millions of dollars to develop and operate, your home PC is incomparable. It’s really comparing apples and pears.

Moreover, it misses the broader point about these firms. Many of the trading algorithms that are run by these firms operate based on inputs similar to those that are used in technical analysis. This should further add weight to the argument that technical analysis can work when applied correctly.

Technical vs. Fundamental
No trader should do their analysis in isolation. They should try and incorporate other points of view and analysis into their decision making in order to build a fuller picture.

Having said that, there are at least two advantages that Technical Analysis has over the likes of the more research heavy fundamental analysis.

Less Opinionated

External research reports that are based on fundamental inputs are often way more subjective. You have to draw a conclusion of the long-term prospects of a company, commodity or cryptocurrency based on a range of different factors (Economic growth, sector growth, CEO vision).

Happy new month

It's ALT season........

PerfectMatchNG:
It's ALT season........

Teach us, boss.

By the way, I'll be glad to have your contact. Can I mail you?

Can you please finish this?

Ohyinyeah:
Can you please finish this?

No

PerfectMatchNG:
No

Why?

Ohyinyeah:
Why?

time