Alchemy for the digital age: turning charts into profits

TO ACADEMIC economists, technical analysis is a pseudoscience, rather like water divining, or alchemy. The academics contend that traders are in fact not using technical analysis at all, at least not exclusively, or else are not actually profitable. One particular study described technical traders as “noise traders”, as opposed to “news traders”, concluding that technical analysis is unprofitable.

But thousands of traders swear by chart indicators with esoteric names such as head and shoulders indicators, dead cat bounces and candlestick charts. Many “chartists” are also highly profitable. Are they wrong?

The efficient markets hypothesis says that liquid financial markets should follow a “random walk” based on new information. According to the hypothesis, predictable patterns in price movements shouldn’t last, because as soon as they become widely known to traders, they will be arbitraged away. Patterns such as the “head and shoulders” have been talked about since the 1930s and have never been conclusively proven to work. Markets may not be totally efficient, but profitable inefficiencies do not last long.

That perhaps explains the advice of David Jones, chief market strategist at IG Markets. According to Jones, technical analysis is still a useful tool, but traders need to realise that “there is no holy grail” for making profits. “It definitely adds value” he says, but “a lot of traders overcomplicate it and get hurt trying to pick tops or bottoms.”

Jones argues that successfully using technical analysis is mostly about exploiting mass psychology and price momentum – “you don’t want to go against market sentiment,” he says. “Even if you think that the gold price is too high, if the trend is for it to keep climbing, you need to be aware of that.” Jones quotes Keynes – even if you are right, the market can stay irrational for longer than you can stay solvent.

Sandy Jadeja, technical analyst at City Index, goes one further. He argues that technical analysis functions best as a way of picking of exit and entry points to trades – as a “decision making tool”. But he also stresses: “90 per cent of trading is psychology.” Like Jones, he says there is no guaranteed technique for profitable trading – rather it is all about experience, and technical analysis is just one tool for traders to use.

Interestingly, the academics might be moving onside. Several recent studies have exposed the (inexplicable) persistence of momentum in predicting stock prices while behavioural finance economists are increasingly stressing the systematic failure of “rational markets”. Perhaps the City’s technical analysts will have their day yet.