31 May 2022
In relation to investment, technical analysis has been in use for well over a hundred years in various forms. While today there are many different variations of historical technical analysis strategies, one question is still prevalent. Is technical analysis a self-fulfilling prophecy?
There is no getting away from the fact that technical analysis is a means of predicting the future based on historical data.However, those who argue that technical analysis is not a self-fulfilling prophecy will point toward investors who don't use such indicators. Any stock market is basically an information exchange where different views and opinions come together to create a consensus. So, if the consensus is not based on technical analysis, it is undoubtedly not self-fulfilling?
Stock markets are based on the concept that all known information, and sometimes information not in the public domain, will come together to find a fair price for a share. When a company is travelling from point A in its development to point B, there will likely be significant fluctuations in the share price. These short-term fluctuations tend to attract the attention of those using technical analysis as a means of deciding which shares to buy and sell.
It could be argued that the short-term impact of technical analysis is something of a self-fulfilling prophecy. For example, volume on a particular stock could increase dramatically if the shares fall through a support level or break through a resistance level. This short-term injection of volume has the potential to magnify the technical signal and share price movement.
If a share price breaks through a resistance level, this can often attract short-term traders looking for a short-term profit. Depending on the size and liquidity of the share in question, this could create a stock shortage which could enhance any short term price movement. As a result, potential sellers may step back, and more buyers step forward, creating a short-term spike.
We have seen this time and time again, a share price falling through a support level before a significant drop. Those using technical analysis can take short-term control of the market, prompting traders to go short while others use their stop-loss limits. This kind of volatile movement may encourage potential buyers to take a step back, flooding the market with stock. It is not difficult to see downward movement exacerbated by a short-term sell-off in this situation.
Even though numerous investors use technical analysis to try to predict medium and long-term share price movements, many would argue the powers are diluted. While a sudden flurry of buyers or sellers can influence the short-term direction of a share price, this is more difficult in the medium to longer term. You may see value investors coming in, arbitrageurs spotting an anomaly against other similar companies, similar to the waves on the sea; eventually, the spikes flatten out.
Many people often overlook one of the main benefits of technical analysis regarding short-term/day traders. These relatively small windows of opportunity tend to attract significant volume, substantially improving liquidity. As a result, it is much easier to arrive at the "fair value" of a share price if there is significant liquidity, i.e. more opinions to consider.
It isn't easy to justify the opinion that technical analysis is a self-fulfilling prophecy. Yes, that sudden injection of interest on the upside or the downside could cause a share price spike/sell-off in the short term. However, in the medium to longer-term, many other strategies would come into play and dilute the impact of technical signals.
Here at Global Investment Strategy UK Ltd, we appreciate the relatively small margins on which many day traders operate. Our investment in the latest technology allows us to create efficiencies and maintain a competitive charging structure for our clients.
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