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Does Technical Trading Really Work? Technical Analysis 101


So we've established that past prices do impact future prices to some extent. But can you predict future prices with a chart alone?

I certainly can't.

I'll concede that technical analysis doesn't make predictions -- but bear with me. The problem with this claim is that the word "prediction" conjures up crystal-ball-style connotations. Technicals aren't a crystal ball, and I don't know a single professional trader or analyst who believes they are.

In practice, technical analysis is a way to find high-probability setups in reaction to the market -- trading setups that factor in potential price barriers such as supply, demand and market mechanics and that give the trader cues about the market move with the highest likelihood. Charts can't help a trader predict a stoc'’s exact day-to-day price movement for the next five years, but they can help generate consistently profitable trades with preset price targets and stop loss levels.

Technicals can help you identify important levels on a stock's price chart and then react when something actionable happens.

As an investor, there's a difference between being right and making money. Predictions are great for people who like being right, but technical tools are more valuable for investors who like making money in reaction to important market moves.

Myth 2: Academics Say Technicals Don’t Work

In the past, academia hasn’t been kind to technical analysis. According to prevailing financial and economic models such as Efficient Market Hypothesis and Random Walk Theory, technicals can't work.

But what most critics leave out is the fact that under those models fundamental analysis tools can't work either.

While those traditional academic models have been powerful arguments against technicals in the past, new research suggests that EMH and RWT are seriously flawed. Academic research as early as 1996 noted the fact that real-world market behavior (namely the existence of trends and occurrences of market crashes) makes Random Walk Theory statistically impossible. Similar results have been found to be the case with Efficient Market Hypothesis, which essentially claims that all available information is immediately priced into shares.

In reality, as events like 2008's market meltdown show us anecdotally that it's really how investors feel about that information that's reflected in share prices.

In the past, one of the biggest issues with academic studies of technical analysis has been the fact that the academics conducting the studies weren't particularly good at developing realistic technical trading systems to their studies. Now, as technical trading becomes more widely understood, academic studies are showing statistically significant outperformance from technical strategies.

Maybe even more importantly for retail investors, new work is showing that applying very simple technical strategies to buy-and-hold index investing can dramatically reduce risk and improve returns net of transaction fees. You don't need to be an active investor to benefit from TA.

Myth 3: The Biggest Investors Don't Use Technical Analysis

The idea that technical analysis isn't used at major funds and institutional settings is a common one, but it's another that's factually untrue. While fundamentally driven funds do certainly dominate the institutional landscape, nearly ever major institutional investment firm has a technical research group -- and all institutions employ trading floors filled with technical traders.

Even though purely technical funds and ETFs have only come onto the scene more recently, some of the most successful investors and traders have risen to prominence using an exclusively technical strategy. Big names include the likes of Richard Dennis and Paul Tudor Jones. Even fundamental analysis icons such as Graham and Dodd made mention of technically driven factors in their explanation of the markets.

Must Read: How to Use a Stop Loss

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