Comment

This piece is inspired by the work ofBenoit Mandelbrot (and confirms what I have always known — technicals work). There are two ways one can track, analyse and trade the financial markets — fundamental analysis and technical analysis. Unfortunately for technicians, broader markets view this school of thought with trepidation. The biases against technical analysis:

- Past price patterns are used to predict future prices, whereas markets are a random walk event. The past has little or no bearing on the prices in the future.

- Since technical analysis assumes that “everything is factored into the price”, using past data means technicians are living in the past and splitting hairs on events that are gone and over.

- Most patterns are an exercise in self-fulfilling prophecies. As more and more people use the same software/ tools, the patterns assume significance as more and more people follow such events.

- Technical analysis is based on non-scientific tools and therefore not a pure science. Since no academic/ uniform benchmark exists, it cannot be pursued as a career.

Mandelbrot’s findings:

- Technical analysis cannot be equated with coin tossing, which is a game of pure chance. Since humans (with emotions) are involved in trading, the closing prices of a session do tend to have a “memory effect” on the opening prices of the next session/s. This is especially true when traders have “open” positions brought forward from previous sessions.

- Using fractal analysis, Mandelbrot has proved that spikes in prices are followed by periods of high volatility. This is similar to the fat tails flanking the bell curve. This proves that market actions are not totally random in nature. Volatility tends to occur in tight clusters when traders tend to converge on the action/ inflection points

- Technical analysis is surely not a pure science but a combination of art and science. Since prices are impacted by mass emotions (which are anything but rational), judgment and experience is required to achieve success. These attributes cannot be taught in classrooms from standard textbooks.

- The future price activity can be projected using past data like changes in buying strength, ticket size per trade and market profile of the participants. Technical analysis, to that extent, plays on probabilities.

- Fundamental analysis employs past data (quarterly/ annual results) for basing future projections. If fundamental analysts were to employ “future” data, I would accuse them of insider trading.

- What is immaterial is why technical patterns work. What is important is how well they work. If head and shoulder patterns yield profits, technicians pocket these gains rather than ask why.

- Fundamental analysis can surely be taught in classrooms, but is done so mostly by non-market participants. Technical analysis in contrast is a self-study process, an on the job training exercise where losses are teachers and profits are incentives. Technical analysis is of the traders, by the traders and for the traders —- all practitioners.

- While fundamental analysis is all about data that emanates from the horse’s mouth, the veracity of the data is by no means sacrosanct (remember Satyam?). Technical analysis ignores the “noise” and focuses on what really occurs —- higher volumes means higher participation, sudden price spikes, higher open interest, etc. Technicals focus on where people are putting their money rather than their mouths.

These arguments seem to tilt the balance in favour of technical analysts, who aim to achieve results rather than delve into the causes.

The writer is an active trader