Does Technical Analysis really Work?

Technical Analysis

Have you heard about John Henry? The guy on the news who bought American baseball team Red Sox for $700 million. He owned Florida Marlins before that,  and also he has a stake in the Yankees.

Wondering how he did that? Well, Henry follows the market trends and trades on it, he has made a fortune doing this over the years. He only believes in technical analysis for taking any buy/sell decisions. $10,000 invested in his oldest portfolio would be worth an astounding $1,394,610 today for a 13,846% return – or 29.68% a year.

At least 90% of people consider trading equivalent to gambling, and they absolutely deny the fact that anyone can become rich by trading in stock markets. John Henry has done the exact opposite and he is worth billions now.

Now since we have set the baseline on how profitable technical analysis could be, let’s get straight into understanding more about it.

What comes to your mind when you hear the term ‘Technical Analysis’? If you are a scientist, engineer or IT professional, you may straightaway relate it with your area of work. And if you aren’t one, probably you would take a pass considering it’s something complex or scientific.

But the fact is that technical analysis is totally different than what it sounds like. In layman terms, it’s a proven method to speculate price movements and direction in financial markets.

As per Stockcharts definition “Technical Analysis is the forecasting of future financial price movements based on an examination of past price movements. Like weather forecasting, technical analysis does not result in absolute predictions about the future. Instead, technical analysis can help investors anticipate what is “likely” to happen to prices over time

Let’s take a real-life analogy. Consider you are in a busy shopping street to buy a pair of shoe. There are 100’s of shops selling shoes and you need to select one out of them. There are two possibilities:

  1. You would research about each shop, it’s history, customer service, reviews blah blah blah
  2. You would straightaway hit the doors of the shop which has the most number of customers at that moment.

I guess it’s obvious that you would choose Option 2. It involves less effort and also it’s proven as there are so many customers already trusting that shop.

Technical analysis works in the same way. You look at the price trend to take buy/sell decisions. If the stock price is trending upwards, it means that lots of people are investing in the stock and hence it is a good time to buy. And if the trend is downwards, it means people are selling it, and so you stay away from it.

Option 1 is analogous to Fundamental analysis where the trading decision is backed by various research-based factors like PE ratio, quarterly results, profit/loss, revenue, etc.

The key thing to be successful in Technical analysis is the ability to identify trends. And that’s where indicators and price action helps. For example- Moving average crossover helps you accurately determine when the price trend will change. And believe me, it’s not difficult at all!

Technical analysis is based on a few key assumptions:

  1. Price discounts everything – The stock price at a given point tells you everything about the company’s health. Everything else doesn’t matter
  2. History repeats itself – The human reaction to stock movements ensures that the price history repeats itself. So, your current trading decision can be based on historical price movements.
  3. Price moves in Trends – Once the trend is established, the price moves in the direction of the trend.
  4. ‘How’ is more important than ‘Why’ – The technical analyst would not be interested in questioning why someone bought the stock as long he knows how the price reacted to the buyer’s action.

If you want to learn Technical Analysis in depth, start from the very basics. Don’t directly jump into fancy indicators or candlestick patterns. First, understand what governs the price movement, look at the volumes and trends. Contrary to mass conviction, I would say that price movement is not random at all. It requires a little patience and knowledge to successfully speculate stock prices correctly most of the time.

If you follow technical analysis rigorously, you can build your own profitable trend following system that works most of the time. But the process may be time-consuming, slow, boring and hopefully personally rewarding. Also, it’s possible that the system may stop working over a period of time, but you’ll have all the means to build a new one.  Don’t look for a ready made system built for you, rather invest in acquiring knowledge to build one yourself.

To conclude, I would like to cite this quote by John Henry:

‘There is no Holy Grail [We] only pay attention to what the markets are saying currently, and don’t ask why the dollar is going up or why interest rates are going down. Our philosophy is that if something is going down, we want to be short. Period.’

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