Does Technical Trading Really Work? Technical Analysis 101

BALTIMORE (Stockpickr) -- Some people think you can make money by drawing a couple of squiggles on a chart? You've got to be kidding me.

Is technical analysis the Holy Grail for investors? Or is it just tea leaf reading?

It shouldn't come as a surprise that talking about investing strategies brings up strong emotions among their practitioners. After all, people's money is on the line. But few topics draw the same polar degrees of ire and praise that technical analysis does. The thing is, many of the biggest TA critics don't really understand how technicians actually use their toolbox to make money in the markets.

Today, we'll seek to bust technical analysis myths by shining a pragmatic light on this investing discipline.

Clearly, an exhaustive debate about the usefulness of technical analysis (or fundamental analysis, for that matter) could never be achieved in a single article. That said, I’ll attempt to scratch the surface, debunking some of the more prevalent myths in the technical analysis world.

First, though, let's define exactly what technical analysis is. At its core, technical analysis is the study of the market itself, rather than the goods that trade in the market, in determining the investment-worthiness of a security. While fundamental analysts focus on a company's business to try and get at the share price of its stock, technicians are primarily concerned with price and volume and with the supply and demand factors that actually move shares.

With that definition in mind, let's take a look at some of the biggest myths.

Myth 1: Past Prices Aren't Useful for Predicting Future Prices

One of the most biting criticisms of technical analysis is the idea that there's no way past prices can be a crystal ball for future prices. But that argument is seriously flawed.

Anyone who's ever bought a stock can attest to the psychological impact of watching a position's gains climb or losses mount. It's human nature. That's a good indicator that entry prices do have at least some impact on future behavior. Remember, we judge our performance by comparing a stock's current price against our entry -- and those entry prices are past prices. Because investors' entry prices have a lot to do with their eventual decisions to close their positions (or buy more), it's naive to think that past prices don’t have some impact on how a stock trades in the future.

No, it's not that past prices magically work their way into future prices that's important. Rather, past prices are significant because they are the best way we have to identify pockets of supply and demand in the market.

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.

Ultimately, the merit of any investment strategy should be based on the successes of its best practitioners -- not the failure of those who don’t fully understand it. Plenty of institutional fund managers use technicals as one of their inputs in making investment decisions. And interestingly enough, the TA proponents actually significantly outperform their peers.

According to research done by David Smith, Christophe Faugère and Ying Wang, at the University of Albany and Kedge Business School Bordeaux, "With respect to mean and median values, the performance advantage of technical analysis is slight, but statistically significant. The contrast appears more salient during down markets, and when performance is measured relative to a primary benchmark."

Here's what that outperformance looks like in dollar terms:

A Pragmatic Approach to Technical Trading

While technical analysis has become very popular in recent years, there are still a number of pervasive myths about technical trading that throw people off. Technical analysis doesn't use price as a way to magically peer into the future, it doesn't contradict the latest academic market models, and technicals are being used to successfully manage substantial institutional assets.

It's worth noting that technical and fundamental analysis aren't mutually exclusive investing strategies. In fact, they're quite complementary. No single investment strategy is going to outperform in every single market condition, but if you're a fundamental investor, adding some simple technical tools to your arsenal can help you beat the market during times when outperformance is hard to find. And technicals can also help you limit your risk when the floor falls out of the market.

To learn more about some of the basics of putting technical analysis into practice, check out the TheStreet's Technical Analysis homepage.

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

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