Advantages and Disadvantages of Technical Analysis

You've already covered the basics of the stock market in our previous modules, and now you're taking a more focused approach to your trading journey. Understanding stock exchanges, financial intermediaries, and traded instruments is just the beginning of our exploration.

To succeed in stock trading, you need to develop a point of view backed by intensive research and analysis. This is the reason why technical analysis is widely used as a tool for developing a directional view of a specific stock and defining the trade based on:

• Buy and sell prices (or entry and exit prices)
• Expected reward or return
• Expected risk
• Expected holding period 

You can also think of technical analysis this way – it helps you spot trading opportunities based on the actions of participants in the market. These actions can be best visualised through stock charts, which exhibit patterns over time. Reading such trading chart patterns through technical analysis can help you make informed decisions in the stock market. 

Now, it is impossible to talk about technical analysis without mentioning fundamental analysis. It refers to the method of assessing the intrinsic or real value of a stock. This kind of analysis factors in external influences, events, industry trends, and financial statements. 

Before we dive into the strengths and weaknesses of technical analysis in this chapter, let’s go through an example that will give you more clarity on these two different analysis techniques (technical and fundamental). It will come in handy later.   

Technical Analysis vs Fundamental Analysis – An Example

Imagine you are visiting an exotic country where you don’t understand the language and everything is a new experience for you, be it the culture, weather, or food. On your first day, you get really hungry after an entire day of sightseeing. Luckily, you find yourself on an exciting street with many vendors selling different delicacies. However, you are not sure how to order for anything since everything is unfamiliar and you don’t understand the language either. 

So, what can you do? There are two options:   

1. You take some time to watch the vendors and see which one has the most customers. When you find the busiest vendor, you think they probably have the best food since so many people are going there. So, you decide to go to the same vendor and likely have a tasty dinner.
2. The other option is to visit a few vendors, check their cooking style, ingredients, and then decide whether you like their food or not. By this method too, you are likely to enjoy a dinner that satisfies your taste buds. 

The first option is akin to technical analysis, where you look for the right opportunities based on the market’s preference and current trend. There is no doubt that this method is highly scalable as you are considering all or most vendors. However, just following the crowd might not always be a wise option. 

The second option is like fundamental analysis, where you are researching a small number of companies (or vendors) in-depth. So, you have no doubt about what you are eating. However, the method is not scalable, especially when you are short on time. So, you have a high chance of missing out on better food. 

Now, it’s time to look into the benefits of technical analysis as well as its pitfalls. 

Advantages of Technical Analysis 

Easy to Understand and Access

• In simple terms, technical analysis is straightforward and doesn't need you to be a finance expert. That's why many stock traders like it. It's about doing easy math and using visuals to understand prices. You can make quick decisions with it. Unlike fundamental analysis, you don't have to know a lot about industry trends or financial stuff. So, you can start trading in the stock market without spending too much time learning complex things.

• Technical analysis is appealing because you don't need advanced degrees in economics or finance. You can find online resources, books, and courses to learn the basics and trade wisely. It makes entering the stock market easier for everyone.
• You will find a variety of charting platforms and easy-to-use software solutions that can help you access a wide array of technical tools and indicators (mathematical calculations that offer a detailed insight into the demand-supply scenario of securities). Charting platforms might also have built-in features that enable you to use indicators on price charts and carry out technical analysis. 

Objective Signals

• Objective signals are derived from historical data on volume and price and are one of the biggest benefits of technical analysis. These signals ease trading decisions by providing clear criteria that are easy to quantify. You can minimise emotional bias and subjectivity this way. 
• Most technical indicators as well as patterns are based on mathematical calculations and formulas. Based on inputs like historical volume and price data, these formulas give you specific numbers as outputs. You can then utilise these numbers to decide whether to sell, purchase, or hold stocks. 
• Technical analysis offers you straightforward and pre-specified rules when it comes to signal interpretation. Consider a simple moving average indicator, for instance. It calculates an arithmetic average based on multiple price points over a certain time period. Now, when a short-term moving average shoots above a long-term moving average, it produces a signal for you to buy stocks or invest. In case the short-term moving average dips below the long-term moving average, a sell signal will be generated. 
• In technical analysis, price charts help you to easily visualise price movements. You can check trends, patterns, and more on such charts without putting in much effort or wasting time. This means you can spot good trading opportunities promptly and place orders for maximum return. 

Focus on Market Timing

• Technical analysis helps you to make the most of the trading process by indicating the right time to enter or exit a position. Accurate timing improves your chances of minimising losses and maximising returns. 
• You can identify optimal points of entry with relevant technical analysis tools and indicators. Apart from the moving average crossover mentioned above, signals like a breakout from a chart pattern or a scholastic oscillator can help you determine the right time to enter a trade. Let’s learn a bit about a breakout and scholastic oscillator. But first, you need to understand what support and resistance means.
  • Support and resistance – These terms indicate the price chart levels between which the market’s movement range is limited. Support is the level till which the price falls and bounces back regularly. Resistance, on the other hand, refers to the level up to which the price usually rises and then dips back. 

• • • Breakout from a chart pattern – A breakout pattern is observed when an asset’s price pushes through a major level of resistance or support on the chart. It happens when the pressure of selling or buying is strong enough to go beyond the existing price range. When the price pushes through resistance, it is a buy signal, and when it pushes through support, it is a sell signal.  
    • Scholastic oscillator – This indicator shows the position of the closing price in relation to the high-low range over a certain period. It can go from 0 to 100. The closing price is near the high when the market is on an uptrend (signal to buy). On a downtrend (signal to sell), it is close to the low. 
• Technical analysis helps you identify trends in stock prices early on, which means you can enter positions in line with the trend’s direction to reap gains. Indicators such as moving average, parabolic stop and reverse or parabolic SAR, and Average Directional Index (ADX) can help you confirm and capitalise on trends smartly. Let’s learn a bit about parabolic SAR and ADX:
  • • Parabolic SAR – This method helps in assessing the direction of a stock and determining if there is any potential for a price reversal. It is also helpful for placing stop-loss orders. Such an order is basically a pre-set price at which you exit a trade for minimising losses.    
    • ADX – This technical analysis indicator can be used to gauge a trend’s strength. The presence of a downtrend is measured by the negative directional indicator and the positive directional indicator measures that of an uptrend.

You can also time your exit from a trade efficiently with technical analysis. Many tools are available to help you understand whether a trend is getting weaker or reversing. This way, you can exit before incurring huge losses or make profits when a trend reversal is expected. 

Effectiveness in Trending Markets 

• A market is called trending when an asset’s price moves in one direction (up or down) persistently and consistently over a long time span. In such markets, technical analysis is highly effective in spotting and capitalising on trading opportunities. 
• There are plenty of technical tools and indicators available to help you gauge if an asset is on a downtrend (price is falling), an uptrend (price is rising), or a sideways trend (price is range-bound or between support and resistance).  
• Technical analysis also allows you to embrace trend-following strategies, so you can profit when an established trend continues. Using indicators like moving averages, trend channels, and trend lines, you can identify the dominant market direction and align with it. Both trend channels and lines give you an idea about the direction in which the value of an investment is moving. 
• When you trade with the trend, you can reap profits as prices move in the expected direction. In other words, you buy during uptrends and sell during downtrends. 

Risk Management 

• One of the key advantages of technical analysis is that it helps you manage risk effectively since you can determine the stop-loss level that is right for you. You can strategically place stop-loss orders by using technical indicators and identifying resistance and support levels. For instance, in case of a long position (where you own the security and expect its value to rise in future), you might want to place a stop-loss right below a major support level. 

• Using technical analysis, you can calculate each trade’s risk-to-reward ratio. This ratio essentially compares the potential profit you might make to the potential loss you might incur. Trading chart patterns and technical indicators can help you identify the correct entry and exit points and decide whether a trade has a good risk-to-reward ratio. 

Disadvantages of Technical Analysis 

Inadequate Information

• One of the major weaknesses of technical analysis is that it disregards fundamental factors while focusing solely on historical data related to price and volume. Fundamental factors include information on market sentiment, economic indicators, geopolitical events, and the share-issuing company’s financial health, among other things. These factors can impact asset prices significantly, so their exclusion from technical analysis can introduce inaccuracies.  
• Financial markets are quite complicated. However, technical analysis tends to oversimplify things by only considering parameters like price and volume. So, when you are trading, you might have to account for many other factors and look beyond historical price charts.  
• In case you are a long-term investor, you will need to study economic trends and the fundamentals of an asset. Technical analysis might not give you enough information then. Fundamental analysis will be more relevant for you in this scenario. 

Subjectivity  

• The interpretation of technical indicators and chart patterns can be subjective, as multiple traders can derive different insights from the same indicator or chart. This means variations in trading decisions and a certain amount of uncertainty. 
• While studying chart patterns, what one trader considers as a sensible pattern, another might perceive as noise (information that confuses authentic underlying trends). The following patterns are often misinterpreted: 
• Head and shoulders – This formation is observed when a market trend is about to reverse (from bullish or bearish). Bullish indicates an upward price trend, while bearish refers to a downward trend. 
• Double top – This pattern indicates a bearish technical reversal and is seen after an extended move-up of stock prices. The tops or peaks form when the asset price hits a level that cannot be broken.

• Flag – This pattern formation happens when there is a sharp dip or spike in the price, followed by trading in a limited price range and rounded off with another sharp price decline or rise.  

• Technical indicators such as oscillators and moving averages require traders to set parameters like time periods for calculation purposes. Since different traders might pick different parameter values, the signals generated might not be accurate. 
• If you rely on technical analysis too much, you might develop confirmation bias, which means you will attach more importance to information that aligns with your existing trading positions or beliefs. This can make you ignore signals against your expectations or overlook contradictory evidence.

False Signals

• A false signal is one of those weaknesses of technical analysis that can cost you heavily. When a trading pattern or indicator suggests a certain market movement, but the actual movement turns out to be something different, it is called a false signal. Such signals are misleading or inaccurate. 
• False signals are common and can crop up in the following forms:
• Fake breakouts – If a price seems to break out of a chart pattern, like a rectangle or triangle, and then quickly move back to the pattern, it can cause a false signal. So, if you enter a trade based on this breakout, you might incur losses. 
• Whipsaws – If a moving average crossover gives off a buy signal followed by a sell signal shortly after (or vice versa) it is called a whipsaw situation. This can lead to multiple unprofitable trades in a short time.

• Divergence reversals – Technical indicators such as moving average convergence divergence (MACD) and relative strength index (RSI) can sometimes show divergence from price movements, indicating an imminent reversal. However, if that divergence doesn’t lead to the reversal expected, it can be a false signal. Let’s understand MACD and RSI a little better before moving on to the next weakness.
• MACD – It is a momentum indicator that shows the relation between two moving averages of an asset’s price. The moving averages are based on two different time intervals.
• RSI – This is a momentum oscillator that measures the size and speed of price movements and ranges from 0 to 100. When the RSI is above 70, the stock is considered overbought, which means you can trade it at a price higher than its fair value. On the other hand, when the RSI is below 30, the stock is considered oversold, so you need to trade it at a price less than its fair value. 

Unreliability in Unfavourable Market Conditions 

• In a range-bound or sideways market, asset price movement happens within a narrow trading range. So, there is no clear trend in any direction. And since technical analysis heavily depends on trend identification, it might generate misleading or confusing signals. The following two situations are quite common:

• In a range-bound market, prices can move below or above the established range for a short while and then get back within the range. If you rely on breakout strategies, this can cause false breakout signals and losses. 
• Prices might change direction frequently, too, in a sideways market. This can lead to multiple whipsaw signals, causing losses if you tend to enter trades based on such signals.
• Technical analysis is not suitable for assets with low liquidity and trading volumes. Poor liquidity can cause haphazard price movements and create gaps in charts, which means you won’t be able to depend on technical patterns and indicators.
• In low-liquidity markets, orders can get carried out at prices that are very different from what is expected. In such cases, signals generated through technical analysis might be inaccurate. 

Excessive Reliance on Historical Data

• Technical analysis predicts price movements in the future primarily based on historical data on price and volume. Hence, the underlying premise is that the trends and patterns witnessed in the past will repeat in the coming years too. However, that can pose multiple problems. 
• Only relying on historical data means not accounting for new or unexpected factors, which can lead to biases while forecasting market movements. After all, markets are constantly affected by geopolitical events, economic situations, changing investor sentiment, and other variables. 
• Technical analysis also works based on the assumption that markets are efficient and asset prices reflect all the information available. However, that is not quite true as markets can be inefficient at times. In such cases, assets might be overvalued or undervalued due to a gap in information or incorrect pricing. 
• If you design your trading strategies only based on past data, you might not be able to adapt to changes in market conditions. Since markets evolve over the years, strategies that were effective before might not work out in the future. 
• While using technical analysis, you might subconsciously end up picking only those historical data points or timeframes that align with your preferred strategies and current beliefs. This can lead to an over-optimistic point of view about a strategy’s performance, which means you might incur losses later. 

No Room for Market Fundamentals

• Remember the example we outlined in the beginning to understand the difference between technical and fundamental analysis? Just to reiterate, while technical analysis concentrates on historical data for volume and price, fundamental analysis dives deep into the underlying factors that affect the prices of assets. Hence, technical analysis overlooks the following factors: 

• Financials of a company – Fundamental analysis involves studying a company’s revenue, debt, profitability, cash flow, and overall financial health through balance sheets, income statements, and more. 
• Economic indicators – In fundamental analysis, indicators like inflation rates, GDP growth, central bank policies, and employment-related data are factored in to gain more visibility into broader economic trends that might impact asset prices. 
• Industrial and sectoral analysis – The particular sector or industry in which an asset functions is examined in fundamental analysis. This is because the asset’s value might be affected by industry trends, regulation changes, and competitive dynamics. 
• Geopolitical events – Since global factors can impact markets, too, fundamental analysis accounts for changes in trade policies, international relations, and the latest geopolitical developments. 
• Market sentiment – Fundamental analysis can help you understand market sentiment through data captured from the options market, assessing the impact of news on sentiment, and conducting surveys to read investor sentiment.   

Learn More

To put what we have learnt so far, technical analysis, though used widely, presents both pros and cons for the trading process. On the one hand, the advantages of technical analysis include simplicity, objective signals, focus on market entry and exit timing, risk management, and usefulness in trending markets. On the other hand, its disadvantages are insufficient information, subjectivity, the possibility of false signals, overreliance on historical data, and unreliability in difficult market conditions. 

This is why combining technical analysis with other methodologies or techniques is often necessary to devise a robust strategy. Your skill and discipline as a trader (as well as the distinct market conditions) also make a difference. So, in the next chapter, we will learn how technical analysis can be used in conjunction with fundamental analysis to develop a more comprehensive and successful approach towards trading.