Technical Analysis – Application & Criticism

Numerous researchers have documented the extent to which TA is applied to the FX market. Arnold & Moizer (1984) surveyed South African portfolio managers finding that 93% of respondents used FA with 56% of respondents also utilising TA. Allen & Taylor (1990) and Taylor & Allen (1992) conducted a survey on behalf of the Bank of England (BoE) among 400 Chief FX traders in London. The results showed extensive use of TA on short-term forecast horizons and diminished use on long-term forecast horizons. For short- term forecast horizons (intraday to one week), approximately 90% of respondents reported using TA in devising their forecast, with 60% judging TA to be equally important as FA. For longer forecast horizons (one month to one year) the weight given to FA increased. On forecast horizons exceeding one year, the skew toward FA was most pronounced, with approximately 33% of the respondents relying purely on FA and approximately 85%

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judging FA to be more important than TA. Menkhoff (1997) expanded on Allen & Taylor (1990) finding comparable results, concluding that a weight of approximately 40% is placed on TA when making short to medium term forecasts and that the use of TA

diminishes when longer forecast horizons are considered. Lui & Mole (1998) surveyed 153 FX traders in Hong Kong; the results showed that TA was superior to FA when identifying trend reversals but only marginally better than FA in forecasting trends. Also, the use of TA decreased when longer forecast horizons are considered which reinforces the findings of the surveys mentioned above. Cheung & Chinn (2001) find that 30% of US FX traders are best characterised as technical analysts and that an increasing percentage use TA. Cheung, Chinn & Marsh (2004) confirm previous findings that traders pay more attention to non-fundamental factors at short forecast horizons. More recent surveys have considered the educational background, experience and psychological biases of FX traders with

Menkhoff (1997) refuting the notion that Technical Analysts lack the experience and or education of Fundamental Analysts. The surveyed German technicians did not differ from non-technicians regarding; age, education, position, seniority, their firm’s trading turnover or assets under management. Menkhoff & Schmidt (2005) investigate the use of the B&H strategy, momentum and contrarian opinion strategies practiced by fund managers. The momentum traders were the least risk-averse, and the contrarian traders exhibited signs of overconfidence. Oberlechner & Osler (2008) use survey evidence from 400 North

American FX traders to establish that respondents underestimate uncertainty and overestimate their abilities. They propose that their findings help to explain the high volatility of exchange rates, the profitability of trend following strategies, and the apparent irrationality of exchange rate forecasts. Clements (2010) interviews 13 prominent

Technical Analysts regarding market efficiency, trading strategies, attitude towards risk, and intermarket analysis. Lastly, the 2010 CitiFX Pro Forex Trader Survey conducted online with an international pooling of 3,000 traders found that 53% of the respondents utilise a combination of TA and FA, with 36% declaring they only use TA and 8% stating they adhere strictly to FA.

The first major academic study that considered TA as a research subject was Can Stock Market Forecasters Forecast? (Cowles, 1933). Regarding the performance of TA on the FX market, it was Goodman (1979), Group of Thirty (1985), Frankel & Froot (1986, 1990a, 1990b), and Goodhart (1988) who first brought it to the attention of researchers and was initially met with disdain. It was not until later when Brock et al. (1992) with their pioneering paper presenting evidence on the profitability of several technical trading rules

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(TTS) using the bootstrap methodology did researchers even begin to take notice.

However, successful studies quickly came under scrutiny regarding risk-adjusted returns. Sweeney (1986) was the first to integrate the risk-adjusted performance of TTS compared to the B&H strategy on the FX market, finding no evidence nor explanation for excessive risk-adjusted returns generated by the TTS. Levich & Thomas (1993) applied a similar methodology finding similar results. Allen & Taylor (1990) record the accuracy of individual Technical Analyst’s forecasts over a 1-4 week forecast horizon on three major exchange rates (USD/GBP, DEM/USD and YEN/USD) over a 10-month sample period benchmarked against alternative forecasting methods. They found that some Technical Analysts were able to outperform the alternative forecasting methods which included a: RW, VAR, and ARIMA model. However, they did report a large degree of heterogeneity among the TA-based forecasts. Qi & Wu (2006) tested 2,127 technical trading rules applied to seven exchange rates over the sample period 1973-1998. The rules included; filter rules, MAs, support & resistance rules and channel breakout rules. Their results indicated significant profitability of MA and channel breakout rules for the seven exchange rates. Qi & Wu then applied White’s (2000) reality check bootstrap methodology to

evaluate the rules and the effects of potential data-snooping bias. They find significant profitability at the 1% level for all seven exchange rates, even after data-snooping bias and transactions costs. Park & Irwin (2007), find similar results for EUR and JPY futures, concluding that TA is profitable in the FX and commodity futures markets but not in stock markets, a conclusion also reached by Silber (1994).

Considering the above, it is logical to wonder why TA remains under constant criticism. TA is extensively practised in the Finance industry yet heavily criticised by academics. The most vocal industry critic is perhaps Warren Buffett who jokingly said to an audience at Vanderbilt University in 2005: ‘’ I realised that technical analysis didn’t work when I turned the chart upside down and didn’t get a different answer’’. The most vocal academic critic is perhaps Malkiel, exemplified by his following statement: ‘‘Technical analysis is

anathema to the academic world. We love to pick on it. Our bullying tactics are prompted by two considerations: (1) the method is patently false; and (2) it’s easy to pick on. And while it may seem a bit unfair to pick on such a sorry target, just remember: it is your money we are trying to save’’, Malkiel (2007, p127-128). TA specifically attracts the attention of economists and academics as successful applications question the EMH and RWT, both cornerstones of Economics. Recall that the EMH states that current market prices fully reflect all relevant information. While this is generally accepted, the concept of

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current market prices reflecting all available information is also a principle of DT

(Principle 1: The Averages Discount Everything) and ingrained in TA, therefore highlights slight contradiction on the critic’s part.