Understand fatal flaws of Technical Analysis

One group of people try to identify price changes by looking at historical price trends. Technicians use price charts (so they are also known as Chartists) containing the price data such as the range from high to low, opening and closing prices. This data may be on daily, weekly or monthly, prices may be linear or logarithmic.

It is not possible to go into details of the methods here – there are detailed books available. In essence, they all try to identify key support and resistance levels, i.e. price points that are hard to break on the way down and up respectively. These points depend on lines connecting previous lows (supports) or highs (resistance levels).

In real life, the powerful significance is that there is usually a lot of trading at key support and resistance levels, but it is much harder to tell whether the levels would hold or break. There are intricate formulas that try to solve this problem, but different variations often give conflicting indications, so it is often hard to know what action to take.

The fatal flaw is that past price changes tell you little about future price patterns. Decades of financial research shows that financial asset prices generally move randomly – even though there is some evidence of mean reversion, it is hard to tell where the long-term trend is, and when prices will turn. Seasoned technicians will admit that they are right less than half the time.

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