Technical analysis isn’t infallible

IF YOU talk to particularly dogmatic technical analysts, you often come away with the feeling that their idea of the perfect trader would have zero contact with the outside world – no City A.M., no Bloomberg and no Twitter. The ideal trader would instead fuel themselves on Fibonacci retracement points and takeaway pizza.

But though it can be a useful tool for gaining a clearer picture of a stock’s potential future actions – based on its past performance – technical analysis is not a foolproof or infallible method of making money from the markets. And, despite the way a lot of technical studies of charts are presented, technical analysis is not a science. You don’t get many hedge funds taking on billions in investment because they’re running an algo on Elliott waves.

But technical analysis is a useful study of human behaviour. A stock does not encounter resistance at 1,000p, rather than at 999p, because that resistance has a scientific basis. It encounters resistance at that level because there are a lot of humans sat at their computers who think that if the stock falls below that point it is going to keep on falling, but if it stays above that level then everything is going to be ok.

And though some may trade purely on technicals, there are many strategies that work well which combine fundamental and technical analysis with risk management. For example, when you are looking at a stock, it can be handy to know whether there is a bulk of other investors who are thinking along the same lines as you. Volume indicators, such as oscillators, can help to give you greater insight into a stock, reinforcing your views on its fundamentals. Traders will often watch for a sudden spike in volume for an indication that an identified trend is gaining momentum. Similarly, when volumes drop, it can be seen as a sign that the wind has gone out of the sails of a stock and that a reversal could be on the horizon.

Of course, there are downsides to this kind of approach. Technical analysis of charts is, by its very nature, a backwards-looking approach. And, as the disclaimer goes: “past performance does not guarantee future performance”. Charts don’t take into account an unexpected poor earnings report, for example, though they may indicate that that report has been leaked to the market.

While there are limitations to both technical and fundamental analysis, if you want to be a profitable trader, understanding the limits of both can be the difference between success and failure. By combining the two, you can gain a much clearer and well-rounded picture of the markets, and where they will go next.