The Application and Limitations of Technical Analysis in Modern Trading

What is Technical Analysis and Its Core Principles

Technical analysis programs and methods are one of the most commonly used decision-making tools by modern traders. This analytical system predicts the future price trends of assets by studying historical price data and trading volumes. Unlike fundamental analysis, which considers various factors such as corporate financial statements and macroeconomic data, technical analysis focuses on chart patterns and historical price patterns.

Traders use technical analysis programs to identify trends, determine support and resistance levels, and find the best timing for entry and exit. The core assumption of technical analysis is that all known market information is already reflected in the current price, so by analyzing these price fluctuations, one can infer the next direction of the market.

The Historical Evolution of Technical Analysis

Although early forms of technical analysis appeared as far back as the 17th century in Amsterdam and the 18th century in Japan, the acknowledged founder of modern technical analysis is Charles Dow. As a financial journalist and the founder of The Wall Street Journal, Dow was one of the first to discover that individual assets and entire markets often move according to identifiable trends. His pioneering work evolved into the famous Dow Theory, paving the way for the subsequent development of technical analysis.

Early technical analysis relied on manually drawn charts and manual calculations, but with the popularization of computer technology and the development of modern software, technical analysis programs have become increasingly sophisticated and accessible, and have now become standard tools for professional investors and traders.

The Working Principle of Technical Analysis: Reflection of Supply and Demand

The operation of technical analysis programs is based on the balance of supply and demand forces. Market prices are a direct reflection of the comparison between the forces of buyers and sellers, and behind these forces are the emotions of traders and investors—primarily fear and greed.

Under normal market conditions—characterized by high trading volume and ample liquidity—technical analysis is generally more reliable and effective. Markets with high trading volumes are more resistant to price manipulation and less susceptible to external anomalies, resulting in less distortion of generated signals. In contrast, the effectiveness of technical analysis significantly decreases during periods of low liquidity or unconventional volatility.

Detailed Explanation of Common Technical Analysis Indicators

Traders typically rely on various technical analysis programs and indicators to monitor price movements and discover trading opportunities. Here are some of the most widely used ones:

Relative Strength Index (RSI)

RSI is a momentum oscillator that measures the speed and magnitude of price movements on a scale of 0 to 100. Traditionally, an RSI above 70 indicates that an asset is in overbought territory (potential sell signal), while an RSI below 30 indicates oversold conditions (potential buy signal).

Moving Average (MA)

There are two main forms of moving averages. The Simple Moving Average (SMA) calculates the average price over a specific period, which can smooth short-term price fluctuations; the Exponential Moving Average (EMA) gives greater weight to more recent price data, making it more sensitive to new information.

Moving averages help traders identify trend directions and potential support and resistance levels. A common strategy is to observe the crossover points of short-term and long-term moving averages to generate buy or sell signals.

MACD Indicator (Moving Average Convergence Divergence)

MACD is a trend-following momentum indicator that shows the relationship between two exponential moving averages. The indicator consists of three parts: the MACD line, the signal line, and the histogram, which can help identify potential buy and sell signals.

Bollinger Bands

The Bollinger Bands indicator consists of two side channels surrounding the moving average line. These volatility bands are used to measure market volatility and identify potential overbought or oversold conditions.

Generation of Trading Signals and Risks

Based on these indicators, traders can generate specific trading signals:

Overbought/Oversold Signals: Indicators like RSI issue sell signals when the asset is overbought and buy signals when it is oversold.

Golden Cross and Death Cross: When the short-term moving average crosses above the long-term moving average, this “Golden Cross” is seen as a bullish signal; conversely, crossing below is called a “Death Cross,” which is considered a bearish signal.

MACD Signal: When the MACD line crosses above the signal line, it may indicate a bullish trend, while crossing below may indicate a bearish trend.

However, it is important to be vigilant as technical analysis signals are not always accurate. This is especially true in short-term trading, where indicators can generate a significant number of false signals, particularly in low liquidity markets. To mitigate risks, traders should combine technical analysis indicators with other analytical methods and risk management strategies.

Major Criticisms of Technical Analysis

Technical analysis programs and methods have long been controversial, with many referring to them as “self-fulfilling prophecies”—that is, certain predictions come true simply because a large number of people believe they will.

Self-Fulfilling Prophecy Problem: Critics argue that the effectiveness of technical analysis is due to many traders using the same indicators, resulting in predictable outcomes.

Subjectivity: The interpretation of charts and patterns is highly subjective, and different analysts may draw completely different conclusions.

Market Anomalies: The performance of technical analysis significantly declines during periods of high volatility or when encountering sudden events.

Despite these criticisms, many traders still believe that technical analysis programs are valuable tools, especially when combined with other forms of analysis. Proponents of technical analysis point out that every chart analyst has unique methods of analysis and indicator strategies, making it unlikely that a large number of traders would adopt exactly the same strategy.

Technical Analysis vs Fundamental Analysis

Technical analysis focuses on historical price data and chart patterns, while fundamental analysis assesses the intrinsic value of an asset based on financial statements, economic indicators, and other qualitative factors.

Advantages of Technical Analysis: More suitable for short-term trading strategies, it helps to identify the optimal entry and exit points.

Advantages of Fundamental Analysis: More suitable for long-term investment decisions, used to assess the overall health and growth potential of an asset.

Many investors choose to use both methods simultaneously to fully leverage their respective advantages and make more rational decisions.

Overall Understanding

Despite the long-standing controversy surrounding technical analysis, many professionals tend to adopt a combination of technical analysis programs and fundamental analysis. Fundamental analysis is usually linked to long-term investment strategies, while technical analysis can provide valuable insights into short-term market conditions, which are of reference value to various traders and investors. Regardless of the method used, risk management and prudent decision-making are always the foundation of successful trading.