Why Technical Analysis May Not Work

Technical analysis is one of the most practiced activities in trading. It consists of an in-depth study of the chart and prices, conducted using statistical tools, with the aim of understanding the real condition of the market and, hopefully, obtaining evidence that suggests its future movements. It's a complex activity, which especially at certain levels requires a truly rich background of skills. Its role in trading has always been taken for granted. However, there is no shortage of detractors, or those who consider it not fundamental. The argument most used by this category of people is the following: sometimes (for some, often), technical analysis simply doesn't work. The fact that technical analysis is not infallible is a given. But what does this depend on? In this article, we will try to answer the question. At the same time, proposing a reflection.

Is technical analysis necessary?

Before reflecting on the reasons that cause the failure of technical analysis, it is good to take stock of the role that technical analysis plays, or should play, in trading. The question to answer, in this case, is the following: is technical analysis necessary? If the goal is to understand the market in its complexity, perhaps in a predictive perspective, it is certainly useful to have a tool that implements statistical study criteria, as technical analysis actually does. At the same time, if we consider its fallacy, then it is also true that technical analysis alone is not enough. Therefore, it is necessary, even before the technical analysis itself, to accompany the latter with other disciplines. The reference is, first of all, to fundamental analysis, which proceeds from the study of events that follow each other outside the market, and which can influence it. The reference, although more rare (it is certainly not the most widespread approach), is to institutional analysis. In essence, the declarations of intent of large investors are studied and used to orient oneself in the market. Regular declarations of intent are reduced to COTs, which are also subject to latency periods, but still... It is still an analytical approach, valid especially for medium and long-term trading. The middle way that seems to provide the greatest guarantees is the simultaneous use of multiple solutions. Technical analysis, certainly, but also fundamental analysis, institutional analysis, etc. In this way, even in the worst-case scenario, it is possible to use "one analysis" as a counterproof for the other. A convenient solution, this, to try to minimize false signals.

Structural reasons

That said, many focus only on technical analysis... Or especially on technical analysis. And many see it fail, sometimes often, other times less frequently. The question that will have arisen spontaneously for them is the following: why does technical analysis fail? Well, there could be various explanations, some "not very comforting". We can divide them into two categories: structural ones, which depend on the technical analysis itself; and contingent ones, which depend on the trader's behavior, on the mistakes they tend to make. Let's try to describe them one by one. Let's start with the structural reasons. What's wrong with technical analysis? Some structural flaws could be traced in its dogmas, that is, in the founding principles from which the practices that characterize it proceed. The founding principles are essentially two. The price discounts everything. That is, any event inside and outside the market that can have any significance for the market itself generates an impact on prices. Therefore, it is sufficient to analyze the prices to access the information necessary to understand the present and to elaborate the trades. In a sense, this principle, or rather dogma, is a "declaration of autonomy": technical analysis is sufficient in itself, no other analytical discipline is necessary. History repeats itself. That is, the same reaction always follows a given event. So if a phenomenon is repeated over time, it is relatively easy to guess the consequences and, potentially, the events. Now, these dogmas have a problem... They are dogmas! Assumptions, valid yes, but the result of a marked modeling. In a sense, it could be true that the market discounts everything, as it could be true that history repeats itself. However, there are ample exceptions. And the reason is simple: the market is truly complex, and so are the dynamics that drive investors. Even significant patterns are detectable, but the context is still constantly evolving. Facing it with the rigidity typical of these two dogmas is problematic. Also because if an event contradicts those principles, it is obvious: the techniques that are based on those principles risk losing effectiveness. In particular, the first point appears problematic. Prices may not discount everything because "everything" may not be definable, or not contemplated in the system of thought of traders or the armamentarium of examples and situations that, with varying force, have involved and involve the market.

Contingent reasons

What we have said so far only applies in the case of "perfect technical analysis"; that is, in the event that there were no errors on the part of the trader. An eventuality that is not impossible, and indeed not even improbable. In particular, there are some errors that, committed in good faith, can lead technical analysis to failure. Losing the overall vision. Many think that to get an overall vision, another type of analysis is necessary, while others believe that technical analysis is enough. But still: working belly-to-ground, focusing only on immediate signals, does not allow understanding the real situation in which the market finds itself, and makes false signals more frequent. Complicating your life. Technical analysis is not a kid's game, but it's not even said that it has to be that complex, indeed... Complicated. Even in a perspective of difficulty, adding tools to tools is not the best way to facilitate the understanding of the market. Therefore, go easy on the indicators. Simplifying too much. Obviously, there is also the opposite error, that is, using only one indicator. This can be well designed, and well mastered by the trader, but if used alone, the probability of adopting false signals is more concrete. The ideal would be to use a couple of signals, chosen so that each can act as a counterproof for the other.