Technical analysis is a strong instrument in the trader’s tool kit and, in fact, many investors argue it’s the most important form of research. When a single tool has such a material impact on your decision-making process it is worth appreciating its assumptions and potential limitations.

Stock market models

The validity of technical analysis is based on behavioural finance which studies how social, cognitive and emotional biases affect the price movements of the stock markets.

The two main observations from behavioral finance are:

1. Investors tend to make systematic errors that affect the market and take away the advantages of market efficiency
2. Traders can fail to materialise a loss and, although all indicators show that the market will continue to trend against them, they make the irrational decision to hold their position and hence incur even greater losses

A contrasting model for stock market movement is the ‘Efficient Market Hypothesis’ (EMH) which states that the price of a stock at any given moment represents a rational evaluation of all the known information.

The EMH model has at least two interesting consequences:

1. The return on equity can be expected to be slightly greater than that available from non-equity investments, otherwise equity investors would shift their funds to these safer non-equity investments that would give the same or better return at a lower risk level
2. Because the price of a share at every given moment is an ‘efficient’ reflection of expected value the curve of expected return prices will tend to follow a ‘random walk’, determined by the random emergence of information over time

Combining technical and fundamental analysis

So, how can such models be used in order to make more informed trading decisions?

When entering into a position it is important to understand the market paradigm at the time of the decision with respect to the most relevant economic indicators. For example, if an investor is trading the GBP/USD spread betting market then they should record the current situation and expectations for both economies.

Below is an example of how an investor might combine technical and fundamental analysis when considering a position on the GBP/USD market. In this case the investor is making use of a daily chart.

Technical summary:

• GBP has been gaining against the USD since May of this year and is supported by a firm rising trendline
• The 20-day EMA is above the 50-day EMA which supports the bullish view
• MACD (12, 26, 9) is above 0 and seems to be consolidating with its signal line which may be just another corrective movement in a bull market
• RSI (14) is neutral
• Stochastic (28, 6, 6) is showing signs of bullish divergence
• Summary: the investor could decide to go long above $1.595 with targets of $1.63 and $1.65

Fundamental summary:

The above table/fundamental summary is just a glance at some of the main figures: there are other key indicators that could be included such as money supply, consumer sentiment and building permits. It is also important to take into account the overall fiscal and monetary policy of the central banks and governments involved.

If we try to summarise both forms of analysis, we can observe a consolidating bullish trend combined with a divergence in monetary policies where the US is expanding and UK is pushing for austerity.

So, an investor may decide to take a bullish view on the GBP/USD market and watch out for any changes in the current market paradigm. As long as the new information is in line with consensus, you might expect that the technical trend will continue to be sustained. Any new information that challenges current expectations could manifest in an adverse reaction on the currency pair.

The above regime may sound laborious, however, in my experience, most retail traders do not seem to have the discipline to follow such analysis. On the other hand, it is a known fact that most retail traders are net losers so it might be worth putting in the extra effort.

Good luck and happy trading.

Shai Heffetz

Published: 18 November 2010

You should under no circumstances consider the information and comments provided as an offer or solicitation to invest. This is not investment advice. The information provided is believed to be accurate at the date the information is produced.