Why Technical Analysis Doesn’t Always Work

Stock traders know that technical analysis works because people consistently repeat behaviors under similar circumstances. For example, the technical-analysis concept of a breakout is powerful because, over decades of analysts following prices, a breakout reliably signaled the end of a trend many, many times.

While breakout is powerful, it isn’t always correct. You will run into situations where a breakout is not respected and the price resumes the direction it was headed in the first place. In short, some breakouts are “false” — they lead you astray.

Keep these points in mind when you use technical analysis:

  • Technical analysis isn’t infallible. The biggest mistake that beginning technical traders make is attributing too much reliability and accuracy to technical methods. Experienced technical traders know that no technique works all the time. In fact, many techniques work only when the majority of market participants believe that they will work, forming a self-fulfilling prophecy. As long as you can identify what technical theory has a grip on the market’s imagination at any one time, you don’t need to care whether the theory is scientifically verifiable. Your goal is to make money, not to be scientifically pure.

  • Technical analysis doesn’t produce hard evidence. Understanding that no technique works all the time helps you overcome doubts raised by critics who say that the whole field of technical analysis is not worthwhile because techniques are not 100 percent reliable. Because a method doesn’t work all the time isn’t the right criterion for evaluating it. Just because the meteorologist is wrong 50 percent of the time doesn’t mean you should take off in your Cessna when he’s forecasting a violent thunderstorm in the next hour.

  • You determine the best analytical method for you. In financial markets, the value of an analytical method is determined by whether it helps you to consistently make more money than you lose. Notice that this statement has two components: The method and you. The “you” variable is why two traders — whether newcomers or grizzled old hands — can use the same method but achieve very different results.

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