rel="nofollow" href="#x_11_i147">Figure 1.7.
Figure 1.7 Mean Reverting versus Non–Mean Reverting Approaches.
Advantages and Disadvantages of Technical Analysis
The advantages of applying technical analysis to the markets are:
• It is applicable across all markets, instruments, and timeframes, where price patterns, oscillators, and overlay indicators are all treated in exactly the same manner. No new learning is required in order to trade new markets or timeframes, unlike in fundamental analysis where the analyst must be conversant with the specifics of each stock or market.
• There is no need to study the fundamentals of the markets traded or analyzed in order to apply technical analysis, since technical analysts believe that all information that impacts or potentially may impact the stock or market is already reflected in the price on the charts.
• Technical analysis provides a clear visual representation of the behavior of the markets, unlike in fundamental analysis where most of the data is in numerical form.
• It provides timely and precise entry and exit price levels, preceded by technical signals indicating potential bullishness or bearishness. It has the ability to also pinpoint potential time of entry via time projection techniques not available to fundamentalists. Fundamental analysis does not provide the exact price or time of entry.
• It makes the gauging of market risk much easier to visualize. Volatility is more obvious on the charts than it is in numerical form.
• The concerted effort of market participants acting on significantly clear and obvious price triggers in the markets helps create the reaction required for a more reliable trade. This is the consequence of the self-fulfilling prophecy.
The disadvantages of applying technical analysis are:
• It is subjective in its interpretation. A certain price pattern may be perceived in numerous ways. Since every bullish interpretation has an equal and opposite bearish interpretation, all analysis is susceptible to the possibility of interpretational ambiguity. Unfortunately, all manners of interpretation, regardless of the underlying analysis employed – be it fundamental, statistical, or behavioral – are equally subjective in content and form.
• A basic assumption of technical analysis is that price behavior tends to repeat, making it possible to forecast potential future price action. Unfortunately this tendency to repeat may be disrupted by unexpected volatility in the markets caused by geopolitical, economic, or other factors. Popular price patterns may also be distorted by new forms of trade execution that may impact market action, like automated, algorithmic, or high-frequency program trading where trades are initiated in the markets based on non-classical patterns. This interferes with the repeatability of classic chart patterns.
• Charts provide a historical record of price action. It takes practice and experience to be able to identify classical patterns in price. Though this skill can be mastered with enough practice, the art of inferring or forecasting future price action based on past prices is much more difficult to master. The practitioner needs to be intimately familiar with the behavior of price at various timeframes and in different markets. Although classical patterns may be applied equally across all markets and timeframes equally, there is still an element of uniqueness associated with each market action and timeframe.
• It is argued that all market action is essentially a random walk process, and as such applying technical analysis is pointless as all chart patterns arise out of pure chance and are of no significance in the markets. One must remember that if this is the case, then all forms of analysis are ineffective, whether fundamental, statistical, or behavioral. Since the market is primarily driven by perception, we know that the random-walk process is not a true representation of market action, since market participants react in very specific and predictable ways. Though there is always some element of randomness in the markets caused by the uncoordinated actions of a large number of market participants, one can always observe the uncanny accuracy with which price tests and reacts at a psychologically significant barriers or prices. It is hard to believe that price action is the result of random acts of buying and selling by market participants where the participants are totally unencumbered by cost, biases, psychology, or emotion.
• The strong form of the Efficient Market Hypothesis (EMH) argues that since the markets discount all information, price would have already adjusted to the new information and any attempt to profit from such information would be futile. This would render the technical analysis of price action pointless, with the only form of market participation being passive investment. But such efficiency would require that all market participants react instantaneously to all new information in a rational manner. This in itself presents an insurmountable challenge to EMH. The truth is that no system comprising disparate parts in physical reality reacts instantaneously with perfect coordination. Hence it is fairly safe to assume that although absolute market efficiency is not attainable, the market does continually adjust to new information, but at a much lower and less-efficient rate of data discounting. Therefore, technical analysis remains a valid form of market investigation until the markets attain a state of absolute and perfect efficiency.
• Another argument against technical analysis is the idea of the Self-Fulfilling Prophecy (SFP). Proponents of the concept contend that prices react to technical signals not because the signals themselves are important or significant, but rather because of the concerted effort of market participants acting on those signals that make it work. This may in fact be advantageous to the market participants. The trick is in knowing which technical signals would be supported by a large concerted action. The logical answer would be to select only the most significantly clear and obvious technical signals and triggers. Of course, one can further argue that such signals, if they appear to be reliable indicators of support and resistance, would begin to attract an increasing number of traders as time passes. This would eventually lead to traders vying with each other for the best and most cost-effective fills. What seems initially like the concerted action of all market participants now turns into competition with each other. Getting late fills would be costly as well as reduce or wipe out any potential for profit. This naturally results in traders attempting to preempt each other for the best fills. Traders start vying for progressively earlier entries as price approaches the targeted entry levels, leading finally to entries that are too distant from the original entry levels, increasing risk and reducing any potential profits. This disruptive feedback cycle eventually erodes the reliability of the signals, as price fails to react at the expected technical levels. Price finally begins to react reliably again at the expected technical levels as traders stop preempting each other and abandon or disregard the strategy that produced the signals. The process repeats. Therefore, SFP may result in technical signals evolving in a kind of six-stage duty cycle, where the effects of SFP may be advantageous and desirable to traders in the early stages but eventually result in forcing traders into untenable positions. See Figure 1.8.
Figure 1.8 The Idealized Six-Stage Self-Fulfilling Prophecy Cycle.
1.5 SUBJECTIVITY IN TECHNICAL ANALYSIS
As with most forms of analysis, technical analysis has both objective and subjective aspects associated with its application. It is objective insofar as the charts represent a historical record of price and market action. But it is subjective when the technical analyst attempts to analyze the data.
Analyzing price and market action consists of three main activities, namely:
1. Identifying price and indicator patterns
2.
