Technical analysis is the study of price data and statistical indicators that are formed by market activity. Market activity illustrates the flow of supply and demand. This supply and demand is a reflection of beliefs and opinions translated into human behaviour and specifically, herd mentality. Therefore, technical analysts would argue, price patterns and indicator signals can be categorised based on historical data with a reasonably high expectation that they will occur again at some point in the future. This argument is based on the theory that human behaviour is innate and, although it adapts and evolves over a long enough period of time, it remains basically the same. Technical analysts focus on the herd mentality and how it affects the individual. It is after all very difficult to hold an opinion contrary to popular consensus especially in an arena where you have to make your opinions know, as you do in the financial markets (in the form of trades).
A Little Bit of History RepeatingMark Twain (the American humorist, writer and lecturer) once said that “History doesn’t repeat itself-at best it sometimes rhymes”. This is true for the subject of this article, technical analysis. Although TA is based on using patterns that have previously occurred to predict the moves of the future no two patterns are ever exactly the same. How can they be when you list the variables that determine price action: trading methodologies, the number of participants, the participants themselves, order sizes, market liquidity, the list goes on. We all know that no two pairs of eyes are ever the same but they are similar enough for you to recognise which are blue or brown etc. The same can be said for price patterns and indicator readings; no two are ever exactly the same but they are similar enough that they can be classified and you can draw a prediction as to where prices are likely to move on completion.
Self-Fulfilling ProphecyOne of the major debates surrounding technical analysis is that it is self-fulfilling. Therefore if enough people use TA and trade the set-ups then they will influence the move they endeavoured to predict in the first place, thus harming its effectiveness. It doesn’t really matter which side of the fence you sit on here, the fact is that a degree of self-fulfilment is inevitable but it doesn’t necessarily guarantee the success or failure of the method. If a price pattern emerges it is not as though every technical trader defines exactly the same entry point and pulls the trigger at exactly the same time or the market would not function. Price would jump instantaneously causing massive slippage and partial fills and then collapse as traders took their profits. The opposite of this would of course be true if technical analysis was deemed as a poor method of analysis. In reality we find ourselves at a happy medium. With enough technical knowledge, a robust trading formula and practical pattern recognition you have a strong basis for a profitable edge. The fact that traders use different entry techniques, price patterns, technical indicators or no technical analysis whatsoever means that there is just enough self fulfilling prophecy present to give technical analysis profit potential