Does technical analysis work?

published 1 March 2006

What is technical analysis?

The art of looking at the past price movements and trade volumes (of a stock, index or commodity, for example) and using the patterns and trends to predict future price movements - and make buy/sell decisions. Most technical analysis is done using charts, so that trends and patterns are easy to see. Consequently, technical analysts are sometimes called chartists. It's a very different approach from fundamental analysis: chartists assume that markets and prices are related to the psychology of the market participants more than to factors such as the health and management of the relevant economy, sector or firm.

How does it work?

In its most simple form, technical analysis is simply about identifying the trend lines on a price chart. Trends are plotted by connecting the peaks in a share-price graph to make the resistance line' and the troughs to make a support line'. Between the two lines is the current trading range of the stock, and if you extend the lines you have the presumed future range. Any breakouts from these ranges signal a reverse in the long-term trend (or an inflection point) from bullish to bearish, or vice versa. Finding these inflection points is the key to successful investing: they mark the point where it is time to get out of an old trend and into a new one.

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Are patterns really that easy to spot?

Not often - most technical analysis involves spending hours pouring over charts trying to figure out if something counts as a trend or not, and if so what the parameters might be. Still, some chart patterns are clearer than others. One of the most well-known visual patterns in charting is the head-and-shoulders pattern, but even this can be hard to spot: while it is happening, how can you be sure it is happening? The pattern is a series of three peaks where the middle peak is the highest. The pattern is confirmed by drawing in the neckline' linking the other two highs and lows, and observing the direction of movement. The pattern in chart B suggests a downward reversal because the price has broken back through the neckline. The same pattern inverted would suggest an upward trend.

What about moving averages?

Moving averages are a tool used by chartists to trigger buy/sell decisions. For example, chart C (below) is a graph of the FTSE 100 at the bottom of the bear market in 2003. Chartists hold that where a shorter-term moving average (say 50-day) crosses a longer-term average (say 200-day) as the market is rising, it represents a long-term buy signal. Moving averages can be a useful tool for identifying trends in a market, but chart C also illustrates one of the frequent charges levelled against technical analysis - that it comes too late. By the time the trend is identified, a big part of the move is over. Here, nearly half the market move was made before the buying signal appeared.

What other tools are there?

Dedicated chartists use a bewildering array of analytical tools and technical indicators to alert, confirm and predict. An excellent starting place to find out more is online at StockCharts.com. In addition to the concepts already discussed, the two most important ideas are momentum and relative strength. The momentum, or rate-of-change in a stock's price or trading volume, is often measured by a particular oscillating' indicator, while the relative strength of a stock usually charts how it is performing against a particular index.

Do any of them really work?

Technical analysts make big claims for their art, but there is good reason to be suspicious of the idea that charts alone are the path to riches. However you look at it, future price movements do not cause and cannot be derived from past movements; price charts do not have a life of their own (they are simply a good way of visualising the real-world price movements of a security; and all analysts should be careful of confusing correlation with cause. That said, technical analysis should not be ignored. There are some good arguments in its favour and the best investors see it as an excellent addition to their investing tool kit. Chart patterns simply represent the past behaviour of a pool of investors. Since that pool doesn't change rapidly, we might expect to see similar patterns in the future. And we do: the same patterns recur so often that it isn't wise to bet against them.

So how are charts best used?

In conjunction with fundamental analysis. Many top investors use fundamental analysis to tell them what to buy and technical analysis to spot trends that tell them when to buy. Britain's investing guru Anthony Bolton of Fidelity Special Situations fund is known for his value style of investing, for example. But he also depends on charts. "If I were on a desert island and allowed just one investing tool," he says, " it would be a chart."

Simon Wilson’s first career was in book publishing, as an economics editor at Routledge, and as a publisher of non-fiction at Random House, specialising in popular business and management books. While there, he published Customers.com, a bestselling classic of the early days of e-commerce, and The Money or Your Life: Reuniting Work and Joy, an inspirational book that helped inspire its publisher towards a post-corporate, portfolio life.

Since 2001, he has been a writer for MoneyWeek, a financial copywriter, and a long-time contributing editor at The Week. Simon also works as an actor and corporate trainer; current and past clients include investment banks, the Bank of England, the UK government, several Magic Circle law firms and all of the Big Four accountancy firms. He has a degree in languages (German and Spanish) and social and political sciences from the University of Cambridge.