FX rates seem to move in predictable patterns. This insight has brought into being the entire discipline of technical analysis. For centuries, traders have studied price movements to make predictions. It may then come as a surprise to learn that some traders mistrust technical analysis, but many traders and analysts are openly hostile to charts. A range of criticisms exist, some aimed at single technical tools such as the RSI, and others at the discipline itself. Given most retail FX traders are technical analysts, it is important to be aware of these criticisms. Traders working in the commodities markets (outside of precious metals) are most known for making these points, whereas FX tends to be more technical-friendly.
What is technical analysis?
Firstly, a brief recap on technical analysis. Sometimes called charting, technical analysis is the study of past price action to predict future movements. Proponents look at candlestick charts, oscillators, trading volume and other indicators to get a sense of the current position of the market trend. The existence of trends – continuing price moves which carry a certain momentum before failing and reversing – is key to all the claims of technical analysts. Technical analysts do not claim to predict the future with total accuracy. The aim of technical analysis is instead to get a sense of market direction and the overall state of a trend. Some technical analysts use forward-looking tools, such as RSI, whereas others only look at the current market conditions to infer information about the prevailing trend. Various theories on how trends form and reverse exist. Some of these are elaborate, as in Elliott Wave theory, while others are very simple. Few people dispute the existence of trends, but there is disagreement over how far they can be predicted.
Criticisms of technical analysis
Criticisms of technical analysis rest on a few propositions. The most simple is that it just doesn’t work. Or works unreliably. Or that it works but no-one can explain how. There are several variations on this, none of which are accepted by technical analysts. Broadly speaking, there is a split between traders who want an overriding theory of market structure (and mistrust technical analysis), and those who just observe patterns and trade off them, who usually appreciate it. Many fundamental traders think technical chart patterns are a self-fulfilling prophecy; that is, they only happen because traders expect them to. This is not necessarily in conflict with a technical trader who thinks charts work because of the psychology of market participants. Additionally, the subjective nature of some technical analysis tools leads fundamental traders to claim they are unfalsifiable, or based on guesswork. Predictably, technical traders respond angrily to these criticisms. Academic finance, which is often wedded to the ‘efficient market hypothesis’, tends to support the critics. The existence of successful technical traders is probably the best rebuttal, but being familiar with the arguments can help you hone your own skills and maybe shake some assumptions about the markets.
Is technical analysis effective?
In theory, this should be simple to test. In practice, backtesting and live trading results tend to vary quite widely. Some fundamental traders claim that technical strategies do not beat chance over the long term. Several studies have been carried out that claim, with the following (contested) findings:
- Some patterns work, but only in certain market conditions.
- No patterns work consistently in all markets.
- Backtested strategies often fail in live trading.
Some traders disagree with one or all of these points, while others agree with them and claim the skill of technical analysis lies in matching the indicator to market conditions. Point 3 has been frequently observed by traders, and is one of the arguments for using demo accounts over backtesting. In some markets, notably certain industrial commodities, technical analysis is less commonly used. This is because those markets have fewer retail traders, fewer speculators generally, and often involve physical delivery. The price of copper is more closely linked to supply, consumption and delivery than market sentiment. This doesn’t mean that traders in those markets completely ignore technical factors, but they carry less weight. Few people would deny concepts such as support and resistance can be valid, but for more exotic technical strategies such as Fibonacci retracements there exist many harsh critics. One of the most common complaints is that they are a self-fulfilling prophecy – because traders expect a reversal at a key Fibonacci level, they trade accordingly and make it happen. If enough traders sell their holdings because they think it has failed to break a key resistance level, this will decrease the price as it creates a market with many sellers and few buyers. This might seem an academic point; why should traders care if a price reversal happens so long as it does? But the problem arises if Fibonacci levels do not represent anything real about the markets. Speculators who believe in them will likely be outweighed by institutional investors who do not, meaning major market moves will ignore them, and wipe out technical traders.
When does technical analysis work?
Academic finance and traders have agreed on a few ‘best’ places for technical analysis: the FX market, the JPY in particular, any market that is highly liquid with no insider information, and markets with lots of retail traders. Retail traders do not have currency requirements for their business operations, like most corporate and institutional clients, and tend to prefer technical over fundamental analysis. More generally, speculators tend to use technical analysis more than hedgers. That means markets where large volumes are controlled by hedgers, particularly industrial commodities, are less appropriate for technical analysis. If technical patterns are self-fulfilling, we would expect them to work better in markets with more speculators, as indeed we do.
When doesn’t technical analysis work?
Most technical strategies stop being profitable after they’ve run for a certain period. This could be because they identify a temporary inefficiency in the market, one which is traded away when enough people notice it. Knowing when to exist or adjust a strategy is an important skill; just because something has been profitable for months or even years doesn’t mean this will continue. Oscillators are fairly controversial. Many traders use them to flash buy or sell signals using a pre-set level, such as an RSI above 80 indicating overbought conditions. This raises the obvious question of what 79.9 means. Algorithmic traders using the RSI will automatically enter and exit trades and specific levels. Manual traders have more leeway, and can avoid these errors. Finally, certain markets are less effective places for technical analysts. Obscure currencies, thinly traded stocks, or commodities are the main culprits. These are markets where there is a strong information disadvantage (thinly traded stocks), low volumes, and a high percentage of hedgers compared to speculators. All of these will tend towards a fundamentals-driven market rather than a technical one.
Many traders, especially algorithmic traders, backtest strategies before running them. This means they take a period of real market data and record how their strategy would have performed in those conditions. Backtesting can give insights into whether a strategy will work in a particular market. Unfortunately, it also runs the risk of fitting your strategy to that period. It is possible to create a strategy that perfectly fits the historical data you are using, but that won’t work going forward. The best way to avoid this problem is to run any backtested strategies on a demo account. This will give you an idea if the strategy can work in a live setting. Of course, you will never know if a strategy works until it is running on a live account – market conditions can always change. Even once you set up a winning strategy, they require constant monitoring to make sure performance continues. How Rakuten can help Demo accounts are an important part of testing technical strategies. Bearing in mind the risks of backtesting and the potential pitfalls of technical analysis more generally, why not open a free demo account today and start trading without risking any of your capital?