Technical analysis works for those who apply it correctly because of three primary factors: probability, testability, and diversity of opportunities.
First, understanding the effectiveness of technical analysis requires viewing the concept through a lense of probability, rather than a lense of winning and losing. That is, a successful technician doesn’t have to be right all the time, he/she only has to be right frequently enough to generate a profit above his/her respective benchmark. In some cases, this may mean only being correct 51% of the time. Because markets are not completely random (far from it), patterns are guaranteed to emerge and probability can turn those patterns into profits. This is the most basic foundation for all technical analysis.
Next, testability is vital to successful technical analysis, and any trading strategy which does not utilize the power of backtesting is extremely likely to fail (hint: most retail traders don’t use backtesting tools). Although backtesting will not be 100% accurate, it lends itself to accomplishing the aforementioned objective of having an adequately high probability of success.
Diversity of opportunities
Finally, the diversity of opportunities prevents technical analysis from becoming stale because there are always new securities, markets, and trends for traders to find. Consider all the stocks, bonds, ETF’s, currencies, and derivatives that are currently traded. Now consider all the possible hourly/daily/weekly trading patterns which can exist in those assets, the number is effectively infinite.
Now, imagine a scenario where your strategies have an 80% success rate when backtested and your backtesting turns out to be 65% accurate. For simplicity, let’s also suppose that “correct” trades double your money and “incorrect” trades lose all of it. Additionally, let’s suppose that 35% of backtesting inaccuracies result in losing your entire investment as well. You can test this with a sample investment of $10,000:
- 80% success rate means for every $1 invested you will make $1.60
- Out of 100 cents, 80 cents is “correct” (doubles) and 20 cents is incorrect (goes to 0)
- ($.80 * 2) + ($.2 * 0) = $1.60
- Now, if your backtesting produces an 80% success rate 65% of the time and a 0% success rate 35% of the time, you can calculate your return:
- 65% of $10,000 = $6,500,
- 35% of $10,000 = $3,500
- (6,500 * $1.60) + ($3,500 * 0) = $10,400
- You’ve now made $400 while being wrong a substantial proportion of the time!
- Now imagine if you had done this with $100,000!
**Notably, real “incorrect” trades are unlikely to cause a complete loss of capital and real backtesting failures are also unlikely to do so.
Apply the knowledge correctly
Once again, technical analysis works only if you can apply this knowledge correctly; many traders lack the emotional stability, discipline, and tools required to do so. Emotional stability involves staying calm amidst the rapid changes occurring in front of you and not losing your cool when you take a loss (remember it’s about probability not guarantees). Discipline requires you to research and analyze your strategy carefully, not jumping in until your plan is set. Being disciplined also requires you to recognize when a strategy isn’t working instead of throwing good money after bad. Finally, the right tools (software) is necessary to consistently execute any set of trading strategies. This doesn’t mean multi-million dollar trading floors (unless you are managing billions of dollars), however, it does mean having software that allows backtesting, responds quickly, and is visually understandable.
These are the external and internal components that make technical analysis work.