Technical Analysis – A Self Defeating Science

Technical Analysis

 Technical analysis – “Technical analysis is a trading discipline employed to evaluate investments and identify trading opportunities by analyzing statistical trends gathered from trading activity such as price movement and volume” – Investopedia.

Simply put technical analysis is studying historical patterns formed by stock prices and predicting whether the pattern will continue or will there be a ‘trend reversal’, with the possibility of money being made on both sides.

Technical analysis is based on three main assumptions:

1.     The market discounts everything: Technical analysts assume that the price of a security has already discounted all the information available in the public as well as non-public domain.

2.     Price moves in trends: Stock prices are likely to follow a trend, whether in the short, medium or long term.

3.     History tends to repeat itself.

The assumptions themselves feel a little farfetched. Technical analysis cannot predict nor have views about things like government policy, new products being launched by a company or of gross mismanagement bythe company. These are real factors which affect the price of a stock but proponents of the technical analysis assume that the entire universe of information of the stock has been factored in and that the effects of the news can be gauged from historical data.

Technical analysts actively talk of removing emotions from trading and of following strict formulas or stop losses, but themselves trade on information derived from the emotions of other market participants.

Technical analysts use various tools and studies to arrive at a variety of conclusions, like the support and resistance levels of stocks using charts orstrength of a trend using Average Directional Index (ADX).There are also toolslike Ichimoku clouds, Bollinger bands, Unirenko bars and Elliot Wave theories each having its own benefits and drawbacks and similarly supporters and opponents. Some analysts consider one tool to be the holy grail, the one sign which tells all, while another analyst may find same the tool to be entirely useless.

The use of technical analysis has also gained popularity due to variousstudies being available at the click of a button on your trading portal or simply for your understanding on google. Technical analysis tools areoften marketed as get rich quick strategies, with a new ‘best indicator’ available every year. But this popularity does not mean that its right.

Let’s look at it logically, if a technical analyst can derive and conclude that a stock will have a positive or negative movement from a chart or a formula and if all technical analysts everywhere can use the same metric and see the same conclusion, should they not all make money, always?

If Technical Analysis is Sacrosanct, then it is a self-defeating science.

Technical analysis suffers from information cascading or herd behavior. Let’s say, for example, there are a bunch of people who have utilized the same technical analysis metric and hence arrived at the same trading range for a particular transaction. They all have a hypothetical long position with a target of Rs.1150 and have placed their stop loss at Rs.1000, with the stock currently trading at Rs.1100. Now let’s say that their analysis was wrong and the stock starts to fall and hits the stop loss. Since everyone has placed their stop loss at Rs.1000 there will suddenly be heavy selling in the market, looking at this, other traders in the market would start selling their positions as well, leading to a further fall in the stock price and prove the technical analysts that their analysis was right and their stop loss was at an appropriate level. But is it really so?

Technical analysis suffers from data mining as well. Analysts have a tendency to see patterns in unrelated data, they back test their theories and draw conclusions which in reality might’ve been affected by several contributing factors.Thepopular random walk theory refutes technical analysis by concluding that chartists only draw conclusions after a trend has already developed and does not signal where it might actually go.

Let’s have a look at the technical analysis based calls published in the Economic Times (ET). ET is India’s most popular business newspaper and has an AIR (Average Issue Readership) of 9,83,000. The newspaper has a section dedicated to markets and within the same has a column oftrading strategies for the day based on technical analysis.

I took previous 3 clippings from recently published editions in order to check their accuracy.

Of course actual returns are subject to what the traders personally do in the market.

I have calculated the net result by following the recommendations to the T. Since technical analysts always stick toa strict stop loss and target, I have done the same.In case stop losses are hit or targets are achieved the net profit/loss has been calculated on that basis, else I have used the closing price of the day.

 

Date: 19th August 2019

 

Scrip Name

Open

High

Low

Close

Result

Net result

Bata India

1484.80

1493.85

1465.60

1473.55

Target price not achieved.

Loss. Rs.11.25

HDFC Life

545.70

560

520

524.55

Target price not achieved, stop loss hit.

Loss. Rs.16.7

IGL

329.10

333.50

322.20

325.70

Target price not achieved.

Loss. Rs.3.4

Amara Raja Batteries

618.10

630.35

618.10

624.40

Target price not achieved.

Loss. Rs.6.3

Date: 20th August 2019

Technical Analysis

Scrip Name

Open

High

Low

Close

Result

Net result

Axis Bank

685.15

685.20

669.50

672.35

Target price not achieved.

Loss. Rs.12.8

Trent

474.85

478.95

469.20

475.7

Target price not achieved.

Profit. Rs.0.85

Dr. Lal Path Labs

1185

1190

1161.75

1184.2

Target price not achieved.

Loss. Rs.0.8

Biocon

215

220.45

211.05

218.2

Target price not achieved.

Loss. Rs.3.2

Date: 21st August 2019

Scrip Name

Open

High

Low

Close

Result

Net result

Tata Motors

123

123

109.5

112.40

Target price not achieved, stop loss hit.

Loss. Rs.6

Ramco Cements

720

723.4

705.6

710.90

Target price not achieved.

Profit. Rs.9.1

LIC Housing Finance

471.2

476.8

457.3

463.40

Target price not achieved.

Profit. Rs.7.8

Apollo Tyres

165.2

166.25

160.25

162.45

Target price not achieved.

Loss. Rs.2.45

The above goes to show that technical analysis is not always correct.

The most popular paper in the country has published analysis conducted by popular trading houses, which out of 12 instances hasnot achieved its targets even once. It has hit the target stop loss twice though. Now if a reader has actively been following what the learned analysts have to say, he/she would have lost more money than he made.

Technical analysis is not all wrong either, yes one can gauge market sentiments from looking at information such as the volume of trade, open interest and the popular relative strength index (RSI). But to say that it can actively predict movement is not an accurate statement. It can give traders a range to enter a stock or exit and some information about the sentiment but it cannot predict the future. Technical analysis should therefore be used in conjunction with fundamental analysis, because in the long run fundamentals should prevail in the market.