The Psychological Utility of Technical Analysis

Today I am starting an occasional series on one of the most fascinating and essential topics in currency trading; the interaction between the psychology of the market and the decisions of the individual trader. I hope these observations are useful; reader comments are welcome.

Technical analysis is sometimes studied as if it contains a grain of secret knowledge or portrays an intrinsic truth about currency movements. Often it is said that a specific chart formation will produce a specific price movement.

Technical analysis does nothing of the sort. A chart is a reflection of past prices, nothing more. In itself a graph cannot predict future price movements. A currency does not trade up or down because of a formation on a chart. It moves because market participants make basic assumptions about future price behavior based on the record of past price action. A charted history of price action is the cumulative story of thousands of trading decisions; it is a record of the past behavior of thousands of individual traders.

Price information is meaningful only because traders’ decisions give it predictive power. A simple proof of the limited forward intelligence of historical price action is the well attested notion that fundamental developments always trump technical analysis. If the Federal Reserve raises rates unexpectedly or the Chinese Government announces it will no longer buy US Treasuries there is no chart formation that has ever existed that will prevent the dollar from rocketing up in the first instance or plummeting in the second.

Technical analysis does not produce price movement. I state the obvious because in the endless attribution of trading cause and effect to ‘the market’ it is easy to lose sight of the actual composition of the market--thousands of individual decision makers. The translation mechanism for technical analysis runs from the information contained in a chart, through the assessment of that information by market participants to the trading behavior of those individual market participants.

Another way to approach this idea is to ask, just who is the ‘market’ and what is it trying to accomplish every day. It is likely that much of the $3.2 trillion daily volume in the FX market is speculative. Everyone in the currency market from the hedge fund trader with $1 billion under management, to the euro trader on the Deutsche Bank interbank desk to the retail trader in her study, is trying to do exactly the same thing, take home daily trading profits.

Interestingly, the overall worldwide foreign exchange trading volume in 2007, the year of the last measurement, increased almost 50% from the prior survey in 2004 of $1.9 trillion daily. The counterparty reporting segment to which retail foreign exchange belongs boosted its share of turnover to 40% from 33% according to Bank for International Settlements in Basel (BIS, 2007) which conducts the tri-annual survey.

To return to my previous point, if every market participant is attempting to do the same thing, namely wring trading profits from the day’s activities, how do they all go about it?

The first thing every trader does, in New York, Tokyo, London and in every land in between is to pull up charts and look for trading opportunities. Every trader looking for profit is judging the same charts. Everyone sees the same price history, and everyone identifies the same potentially profitable chart formations. And, in the absence of other factors, the majority of traders will come to the same trading conclusion based on the observed chart formations.

If euro has been in an up channel for two weeks and is approaching the bottom of the channel most traders looking for an opportunity in euro will bet on the continuance of the up trend and the maintenance of the channel. They will place buy orders just above the floor of the channel. And much of the time the charts will have been proven correct, the euro will indeed bounce from the floor of the channel. But it bounces not because, for instance, the ECB is expected to raise rates at some future date, but because of the fit between the goals, information and assumptions of the market’s traders.

Traders need profits, all charts contain the same information and all traders operate with similar assumptions about market behavior based on chart formations. If enough traders place their buy orders above the bottom of the channel it becomes likely that the euro will bounce off the floor of the channel and continue the upward channel formation, barring external events of course.

There is powerful self-fulfilling logic in technical analysis. It works, because everyone trading believes it will work and makes their trading decisions accordingly. For a retail trader this knowledge is the most accessible and effective trading strategy that exists.