Introduction
The question of whether technical analysis can truly lead to profitability has been a topic of heated debate for decades. Can you really make money by conducting technical analysis of the financial markets or is it just snake oil? This question has become even more pertinent since trading and investment largely moved online, where everyone now has access to a wide range of technical analysis tools more often than not for free.
In this comprehensive review, we analyse a ground-breaking study that has significantly contributed to this discourse. The study, while conducted nearly 20 years ago, provides a detailed examination of the profitability of technical analysis, offering valuable insights that remain relevant even in today’s rapidly evolving financial markets.
The study we’re reviewing, “The Profitability of Technical Analysis: A Review” is a comprehensive analysis of technical trading rules across various markets, including stock markets, futures markets, and foreign exchange markets. The authors (Cheol-Ho Park and Scott Irwin), conducted rigorous tests on the profitability of these rules, taking into account factors such as risk, transaction costs, and post-sample performance. They also employed sophisticated statistical tests to ensure the validity of their findings.
The findings continue to provide many valuable insights for traders and investors today. It offers a deep understanding of the mechanics of technical analysis and its potential for profitability.
In Trader.yt’s review of their review, we’ll explore the study paper in detail, discussing its methodology, key findings, and implications for traders. We’ll also examine the study’s limitations and the critiques it has received over the years.
Our goal is to provide a comprehensive and accessible overview of the study, enabling you to understand its findings and implications, and apply this knowledge to your own trading strategies. Whether you’re a seasoned trader or a beginner, this review will provide valuable insights into the profitability and effectiveness of technical analysis.
So, let’s dive in and explore the question: Can you really make money using technical analysis?
Background of the Study
The Origins of Technical Analysis of the Financial Markets
Technical analysis has a long history, with its roots in the West dating back to the early 20th century yet it was being used as far back as the 1600s in Japan. Over the years, it has evolved from a simple method of analyzing price charts to a sophisticated discipline that incorporates a wide range of techniques and indicators.
The origins of technical analysis are closely tied to the development of the efficient markets hypothesis (EMH), which posits that asset prices fully reflect all available information. However, this hypothesis has been challenged by a plethora of alternative theories. For instance, noisy rational expectations models suggest that markets can be inefficient if prices reflect noise rather than fundamental valuations. Feedback models argue that traders’ strategies can influence price movements, leading to trends in financial markets. Other models, such as disequilibrium models, herding models, and chaos theory, further challenge the EMH by suggesting that various market imperfections and behaviors can create profitable trading opportunities.
The Purpose of the Study
The study we’re reviewing was conducted to test the profitability of technical trading rules across various markets, including stock markets, futures markets, and foreign exchange markets. The authors conducted tests on the profitability of these rules, taking into account factors such as risk, transaction costs, and post-sample performance. They also employed sophisticated statistical tests to ensure the validity of their findings.
The purpose of the study was not only to uncover profitable trading rules but also to test the validity of the efficient markets hypothesis. By demonstrating that technical trading rules can be profitable, the study provides evidence of market imperfections that contradict the predictions of the EMH. This makes the study a significant contribution to the ongoing debate about the efficiency of financial markets and the profitability of technical analysis.
The Relevance of the Study in 2023
Even though the study we’re reviewing was conducted nineteen years ago, its findings continue to hold relevance in 2023. The financial markets have seen significant changes over the years, with the advent of new technologies, the rise of algorithmic trading, and the increasing ease of accessibility. Despite these changes, the fundamental principles of technical analysis remain the same, and the study’s examination of the profitability of technical trading rules continues to provide interesting insights for traders and investors.
While the results are interesting, they should be interpreted in light of the changes that have occurred since the study was conducted. The advent of new technologies, changes in market dynamics, and the increasing complexity of financial instruments since, may have implications for the profitability of technical trading rules. So look to complement it with up-to-date knowledge and understanding of current market conditions and derive your own conclusions in light of those additions.
Evolution of Technical Analysis
Technical analysis has evolved significantly over the years, with advancements in technology and the development of new theories contributing to its growth. The study categorizes modern technical analysis into several distinct studies:
| Category | Description |
|---|---|
| Standard Studies | Typically conduct parameter optimization and out-of-sample tests. |
| Model-based Bootstrap Studies | Focus on resampling techniques to assess the profitability of trading rules. |
| Genetic Programming Studies | Use genetic programming techniques to optimize trading rules. |
| Reality Check Studies | Evaluate the performance of multiple trading rules to identify the best-performing ones. |
| Chart Pattern Studies | Concentrate on recognizable patterns in price charts. |
| Nonlinear Studies | Investigate complex, non-linear relationships in market data. |
The evolution of technical analysis has also been influenced by the development of various theoretical models already touched on. These models provide a theoretical foundation for the profitability of technical trading rules.
Benefits of Technical Analysis
The benefits of technical analysis are manifold, and the study provides a detailed examination of these benefits. One of the key benefits of technical analysis is obviously its potential for profitability. The study’s rigorous testing of various trading rules across different markets provides evidence of the potential profitability of conducting technical analysis of the financial markets.
Another benefit of technical analysis is its ability to provide insights into market trends and patterns. Through the use of various technical indicators and chart patterns, traders can identify potential trading opportunities and make informed trading decisions and importantly when not to trade.
Moreover, technical analysis can also help traders manage risk. By providing insights into market trends and potential price reversals, technical analysis can help traders set stop-loss orders and protect their investments or trades from significant losses.
Methodology
The Approach of the Study
The study’s approach comprehensively reviews survey, theoretical, and empirical studies regarding technical analysis and discusses the consistency and reliability of technical trading profits across markets and over time. The report pays special attention to testing procedures used in empirical studies and identifies their salient features and weaknesses. It aims to improve the general understanding of the profitability of technical trading strategies and suggest directions for future research.
The empirical studies surveyed include those that tested technical trading systems, trading rules formulated by genetic algorithms or some statistical models (e.g., ARIMA), and chart patterns that can be represented algebraically (Page 5).
The Types of Trading Rules Examined
The study examines various types of trading rules. Early models in this area provided the first theoretical foundation for the possibility of profitable technical trading rules by taking account of the speed and efficiency with which a speculative market responds to new information. These models hypothesized two types of traders, “insiders” and “outsiders,” and the dynamics between them (Page 13).
The study also examines the profitability of technical trading rules in various different types of markets. The results varied greatly between them. For example, in the early studies, very limited evidence of the profitability of technical trading rules was found in stock markets, yet they often realized sizable net profits in futures markets and foreign exchange markets (Page 27).
It also looks into genetic trading rules, a sophisticated approach in financial markets that leverages genetic programming. Genetic programming is a form of artificial intelligence that simulates the process of natural evolution. This method is used to autonomously develop rules for trading – essentially, strategies for when to buy or sell financial assets like stocks or currencies.
One of the key advantages of using genetic programming in this context is its potential to sidestep the pitfalls of data snooping. Data snooping occurs when analysts inadvertently tailor their strategies based on the idiosyncrasies of the specific data set they are studying, rather than finding genuinely predictive patterns. This often happens when too many strategies are tested on the same set of data, leading to seemingly significant findings that are, in reality, the result of random fluctuations. By using genetic programming, the development of trading strategies is less influenced by human biases or preconceived notions, as the program evolves these strategies based on their actual performance data.
However, this innovative approach is not without its own conundrum. The study points out a potential methodological issue with relying on genetic programming. The concern lies in claiming predictability in financial markets using a method that did not exist during the period being analyzed. For instance, if a genetic algorithm uncovers a pattern that appears to have been predictable in the 1980s, it’s contentious to claim this predictability when the algorithm itself, along with the computational resources required, only became available much later(Page 39). This could lead to a misleading conclusion, as it assumes the availability of advanced tools and analysis methods in a time when they were not actually present.
In essence, while genetic programming presents a novel and less biased way of developing trading rules, thereby potentially avoiding the trap of data snooping, there remains a critical consideration. It is crucial to contextualize the findings within the time frame and technological capabilities of the period being studied, to avoid anachronistic conclusions about market predictability.
The Accuracy of the Methodology
The study acknowledges the challenges and limitations in its process.
Some of these include:
- Data Snooping: This refers to the misuse of data analysis to find patterns in data that can be presented as statistically significant, thus leading to unreliable study outcomes.
- Ex Post Selection of Trading Rules or Search Technologies: This refers to the selection of trading rules after the fact, based on what has already happened. This can lead to overfitting, where a model is tailored to fit the historical data perfectly but performs poorly on new data.
- Difficulties in Estimation of Risk and Transaction Costs: Accurately estimating risk and transaction costs is a challenging task. Misestimation can significantly impact the results of a study.
The document suggests that future research must address these deficiencies in testing to provide conclusive evidence on the profitability of technical trading strategies (Page 2).
The Impact of Time and Market Changes on the Methodology
As we review this study roughly twenty years after its publication, it’s crucial to consider how time and market changes have impacted the methodology and findings of the study. The study itself acknowledges the evolving nature of financial markets and the impact this has on the effectiveness of technical trading rules.
The study was conducted during a time when financial markets were undergoing significant changes. The advent of new technologies, changes in market dynamics, and the increasing complexity of financial instruments were all factors that influenced the markets during this period there was also much less HFT algo activity and much more human trading.
Key Findings
The Main Discoveries of the Study
“The Profitability of Technical Analysis: A Review,” presents several significant findings that shed light on the effectiveness of technical analysis in trading. Here’s a breakdown of the results across different markets:
| Market | Technical Method | Result | Reference Page |
|---|---|---|---|
| Foreign Exchange Markets | Single moving average rules | Demonstrated significant profitability, especially when considering long positions in certain currency pairs. | Page 104, Page 86 |
| Futures Markets | Dual moving average crossover rules | Showed promising results, indicating potential trend-following opportunities. | Page 104 |
| Stock Markets | Various technical trading rules | Found mixed results, with some rules being more effective than others. | Page 27, Page 39 |
These findings suggest that the profitability of technical analysis may vary based on market conditions, the asset class, and the specific technical method employed.
The Profitability of Technical Analysis
As we see above, certain technical analysis strategies, such as single moving average rules, were particularly profitable (Page 104). This suggests that traders who are able to effectively use these strategies may be able to generate significant profits.
However, the study also notes that the profitability of technical analysis can vary depending on a variety of factors, including the specific market conditions and the type of trading position that is taken e.g. as we note in the above section where long only positions were considered for certain FX pairs.
Technical analysis may be particularly profitable in markets where information is rapidly changing and traders need to quickly adjust their strategies in response to new data.
The Question: “Can Technical Analysis Make You Rich?”
The study does provide insights that can help us infer an answer. The authors found that certain technical analysis strategies, such as single moving average rules, were particularly profitable (Page 104). This suggests that traders who are able to effectively use these strategies may be able to generate significant profits. However, the profitability of these strategies can vary depending on a variety of factors, including the specific market conditions and the type of trading position that is taken. For example, the study found that there was a marginal improvement to five and four currencies for moving average rules and channel rules, respectively, when only long positions were considered (Page 86). This indicates that while technical analysis can potentially lead to wealth accumulation, it is not a guaranteed path to riches and requires skill, knowledge, and the right market conditions.
The Long-Term Sustainability of Profits from Technical Analysis
While technical analysis can potentially generate profits in the short term, the sustainability of these profits over the long term is uncertain and likely depends on a variety of factors, including changes in market conditions and the ability of traders to adapt their strategies in response to these changes.
Implications for Traders
The Practical Application of the Findings
The study’s findings have practical implications for traders. The research suggests that technical analysis can be profitable, especially when applied to foreign exchange and futures markets. The study found that single moving average rules generated the best results, followed by dual moving average crossover rules and relative strength index rules (page 104). These findings suggest that traders can potentially use these specific technical analysis methods to guide their trading decisions.
The Potential Risks and Rewards of Using Technical Analysis
While the study provides evidence of the profitability of technical analysis, it’s important to note that there are potential risks involved. The study categorizes modern technical analysis studies and highlights the risks associated with each category (page 82). For instance, some studies lack trading rule optimization and out-of-sample tests, and do not address data-snooping problems. These issues can lead to inaccurate predictions and potential losses for traders.
However, the rewards can be significant. The study found that technical analysis rules generated positive returns including foreign exchange and futures markets. For instance, when only long positions were considered, there was a marginal improvement to five and four currencies for moving average rules and channel rules, respectively (page 86).
The Question: “Does Technical Analysis Actually Work?”
The study provides evidence that technical analysis can work, but it’s not a guaranteed strategy for success. The research suggests that the effectiveness of technical analysis can vary depending on the market and the specific technical analysis method used. For instance, the study found that technical trading rules formulated by genetic programming appeared to be unprofitable in stock markets, particularly in recent periods. In contrast, these rules performed well in foreign exchange markets, with their performance decreasing over time (page 39).
The study also suggests that the success of technical analysis may depend on the trader’s ability to interpret and apply the analysis correctly. The study notes that ill-qualified traders who have little opportunity to acquire valuable information early and little ability to interpret the information may choose to “go with the market” (page 13). This suggests that education and experience can play a significant role in the success of technical analysis. Keeping abreast of fundamental releases will assist traders with interpreting when to react to what technical analysis signals suggest and when to hold of executing solely on their basis.
Critiques and Limitations:
The Criticisms of the Study
We touched on this in the Methodology section earlier. While the study provides valuable insights into the profitability of technical analysis, it acknowledges several limitations in its testing procedures, which could potentially impact the validity of its findings. Let’s address these three areas again:
One of the main criticisms of the study is related to data snooping. Data snooping refers to the misuse of data analysis to find patterns that can be presented as statistically significant, leading to unreliable study outcomes (page 2). This issue is particularly relevant in the context of technical analysis, where the effectiveness of trading rules is often evaluated based on their past performance. The risk of data snooping could potentially lead to overestimation of the profitability of technical analysis.
Another criticism is related to the ex post selection of trading rules or search technologies. The study acknowledges that this could potentially lead to overfitting, where a model is tailored to fit the historical data perfectly but performs poorly on new data (page 2). This could potentially overstate the effectiveness of technical analysis and lead to inaccurate predictions about future market trends.
The study also acknowledges the difficulties in estimating risk and transaction costs accurately. Misestimation can significantly impact the results of a study and can potentially overstate or understate the accuracy of technical analysis (page 2). This is a significant limitation, given that the profitability of technical analysis is often evaluated based on the assumption that trading rules can be implemented without any transaction costs.
In conclusion, while the study provides valuable insights into the profitability of technical analysis, these criticisms highlight the need for caution when interpreting its findings. Traders and investors should be aware of these limitations when using the study’s findings to guide their trading strategies.
Editor’s Note
Personally after 21 years trading futures professionally and starting before the original study looked at here was compiled, I would say technical analysis has made a me a lot of money. But it’s not necessarily a requirement for traders to use it to be profitable, nor even look at a simple chart either for that matter. I certainly haven’t purely relied on it either, I’ve always used it in combination with analysing fundamental events and order flow.
As a short term futures trader with seconds to minutes hold times, I’ve tended to use a combination of order flow on a DOM (depth of market), market profile and 15 minute and 60 minute candles with MACD and DMI but that’s just me. I know an extremely successful gasoil prop trader who I worked on one of the same trading floors as I did, who only ever looked at order flow via his WebICE platform. He found that charts overcomplicated his thinking when trading front month gasoil spreads, so he never used them. He is still hugely profitable and continues trading the same way today.
Many traders starting out look for some sort of holy grail indicator, some secret sauce, whereas I think its probably more important to focus on the dynamics of inter market relationships and fundamentals such as upcoming economic figure releases. Too many times people cry ‘overbought’ or ‘oversold’ due to indicator readouts and helplessly keep selling or buying repeatedly against a stubborn trend. Never outsource the blame of a losing trade to technical analysis being wrong. It’s a tool in a patchwork of considerations, you always own the position. There are a thousand ways to skin a cat and more than a thousand ways to pull money from the markets but the more you learn what’s available to assist you, the more you can settle into finding your own strategy that works for you.
Understanding who else is in the market and what they are looking at will help you exploit them and avoid them exploiting you, be they man or machine. Quite often chart patterns can be a self-fulfilling prophecy and maybe you can find ways to flush others out of positions to your benefit when you figure out where their stops would be. Certainly HFT algos visibly undertake these tactics every day if you watch closely.
Key Takeaways:
- Origins of Technical Analysis: Technical analysis, dating back to the 1600s in Japan, has evolved significantly, incorporating a variety of techniques and indicators. It emerged alongside the development of the efficient markets hypothesis (EMH), which posits that asset prices reflect all available information. This hypothesis, however, has been challenged by various alternative theories.
- Study’s Purpose: The main goal was to test the profitability of technical trading rules across various markets, while also challenging the validity of the EMH.
- Relevance in 2023: Even after 19 years, the study’s findings remain relevant, particularly its challenge to the EMH and its evidence of potential market imperfections.
- Evolution: With advancements in technology and the development of new theories, technical analysis has significantly evolved.
- Benefits: The main benefits of technical analysis lie in its potential profitability, its ability to offer insights into market trends, and its role in risk management.
- Methodology Challenges: The study acknowledges certain limitations such as data snooping, ex post selection of trading rules, and the difficulties in estimating risk and transaction costs.
- Key Findings: Single moving average rules were particularly profitable, suggesting that specific strategies might be more effective than others.
- Implications for Traders: While the study provides evidence that technical analysis of the financial markets can be profitable, it’s essential to understand its limitations and potential risks. Traders should not solely rely on technical analysis but should incorporate other strategies and be wary of market changes.
- Editor’s Note: It’s important to understand who else is in the market and what they’re looking at. While technical analysis can be beneficial, it’s crucial to combine it with other methods, such as fundamentals and understanding inter-market relationships.
Resources
You can download the full 106 page study as a free pdf file here:
Park, Cheol-Ho and Irwin, Scott, The Profitability of Technical Analysis: A Review (October 2004). AgMAS Project Research Report No. 2004-04, Available at SSRN: https://ssrn.com/abstract=603481 or http://dx.doi.org/10.2139/ssrn.603481
“Technical Analysis of the Financial Markets: A Comprehensive Guide to Trading Methods and Applications” by John J Murphy
“Technical Analysis from A to Z” by Stephen Achelis (Second Edition)
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