HEAD OF INTERTRADER.COM
TECHNICAL analysis is by far the strongest tool in my trading belt, but my experience has taught me that it is not enough on its own. The real world, the one fundamental analysis is based on, should have an impact on the decision-making process of a trader.
The validity of technical analysis is based on behavioural finance, which studies how social, cognitive and emotional biases affect the price movements of the stock markets. Its method centres on projecting chart patterns forward.
On the other hand, the efficient market hypothesis (EMH) states that the price of a stock at any given moment represents a rational evaluation of all the known information.
The conclusion from the first would be that past performance may indicate future performance. On the other hand, the latter suggests price moves in a random walk. How do you combine two schools of thought that, on the face of it, contradict each other?
BLACK, WHITE AND GREY
There is no black or white: we live in a grey world. There are instances when there are so many fundamental changes in the world that affect financial instruments – like the recent earthquake and tsunami in Japan or the continuing turmoil in the Middle East – that technical information is not as useful as it is in quieter periods.
Technical analysis is a manifestation of the current market paradigm projected onto the likelihood of future market performance, but when the world changes dramatically there is no prevailing paradigm. The dust must be allowed to settle again before a new paradigm can be formed from the wreckage.
The bottom line is that if you rely only on technical analysis there are certain times when it will be best just to stay on the sidelines and wait. Trying to impose patterns, channels or trends based on a paradigm which no longer exists may drive a decision making process which is not based on reality.
The views and comments in this article are not the views of InterTrader.com. The provision of this information should not be construed in any circumstances as a recommendation or solicitation to buy or sell any security or financial instrument.