When Does Technical Analysis Not Work

Tony Chou runs the Investorz’ Blog; a blog about investing and the finance markets.

Let me start off by giving you Wikipedia’s definition of technical analysis. “Technical analysis is a financial term used to denote a security analysis discipline for forecasting the direction of prices through the study of past market data, primarily price and volume.” Now note here what is specifically mentioned “the study of past market data.” As the saying goes “history repeats itself.” A technical analyst would probably love to believe that, but history doesn’t repeat itself. History, however, OFTEN repeats itself (but not all the time). Hence, there are two situations in which technical analysis does not work.

1)     The markets are being manipulated by someone with a lot of power, such as the government/Fed. Technical analysis reflects investor psychology. And human psychology is the one thing that rarely changes. For example, investors (and humans for that matter) like the number 100. The roundness, perfectness of that number. So according to technical analysis, the $100 line would be a very important support or resistance line (depending on which way the market was going). Since human psychology rarely changes, the technical analysis could depend on the $100 to give support or resistance.

But if someone is manipulating the markets, then technical analysis no longer works. It’s no longer investor/human psychology that’s what’s driving the market, but instead a higher force who has the capability to manipulate the market to suit its own wishes. Technical analysis only works in a free market, and when the market is being manipulated, it’s no longer free.

2)     The market is a crazy mood. In times of extreme fear or extreme optimism, don’t expect technical analysis to help you earn any money. When someone’s in a crazy condition, the person isn’t thinking. He’s acting in ways that no one can predict (even if looking at past data). The market is the same thing.

3) You have to know which technical indicators to look at. Recently I wrote a post about when the MACD indicator doesn’t work. That being said, there are hundreds if not thousands of indicators to look at. Choosing the right one is crucial. For example, MACD doesn’t work when the market is moving in a very small range and not trending.

                

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