7 Reasons Why Technical Analysis Fails

Welcome to VRD Nation. Today, we will talk about a very interesting topic and that is 7 reasons why technical analysis fails. The reason I believe this topic is so important is that a lot of us, spend a lot of time reading books, attending courses, analyzing the charts and treat it like course material that prepares us for trading.

Back in our school or college days, we used to have a syllabus. We used to finish it and then we were ready for the exam and the next stage in life. However, what happens is that after spending a lot of time learning these concepts, when we try to apply these patterns and real life, we don’t get the same kind of consistency as we thought we would get.

This causes losses and frustration because people think that I have spent so much time learning these concepts, spent so much money in understanding these concepts, yet none of these concepts is working out for me.

Based on my own experience and the experience that I had interacting with a lot of students, I will share with you the 7 reasons why I believe that the application of technical analytics fails in real life. The subject itself doesn’t fail, but what sometimes fails is its application in real life.

The first reason I believe that technical analysis fails is that we missed the big picture right now. What does it mean? Well, think about a stock.

We are focusing on the charts of a certain stock, but what we don’t realize is that that stock is not operating in isolation. It is working in a broader spectrum. Our stock might belong to an industry that might belong to a sector and the sector belongs to an overall market, which, in turn, belongs to a certain country.

A stock is not operating on its own, Last year, a student of mine who was analyzing the chart of Maruti, looked at the chart and he saw a bullish pattern forming on Maruti.

He asked me for my feedback on whether a long trade was possible or advisable on Maruti. I then looked at the chart of Maruti and the chart was looking fine and there was nothing wrong with it.

What was missing though, in that analysis was the broader context of the market itself. So last year when we were in the midst of this Covid crisis, every rally in the stocks were getting sold into, and in that kind of a market context where there is bearishness in the market, what do you think is going to happen to the analysis that you’re doing on a specific stock?

Maruti can be a very strong stock in it and can be making a certain pattern that you believe is very strong, but it cannot keep going up. If the market comes down with that kind of momentum, the same thing is true within the sector itself.

If the auto sector is correcting significantly and you are seeing a bullish pattern in one of the auto stocks, what do you think is going to happen? Most likely what will happen is that maybe the stock will move in your favor for some time, but then eventually it will follow the sector or the industry that it belongs to.

This is a mistake that I see a lot of people making that we are obsessed about a certain stock and are obsessed looking at a chart trying to find a certain pattern in a chart. Yet, what we miss is the bigger picture. If the sector, the industry, the country and the economy itself is not doing fine, the market is will not be fine.

The patterns that you are seeing on those charts will most likely not sustain. Hence it is the primary thing that you ought to keep in mind that the broader context of the market is important. We should hence always ask ourselves, what is the market context and what is the context of the sector? Is it a bullish market or a bearish market? Is it a range-bound, high or low volatile market?

Once you have a broader understanding of the market context and the understanding of the sector, and then when you align the pattern that you’re finding in your stock, to the broader market in the industry, you have a higher likelihood of success.

Now, the second reason why a technical analysis fails is because of the wrong location. Now, what is the location? Location is the place at which a pattern is appearing. Depending on the place and the location, the pattern can be reliable or unreliable. The easiest way for me to explain this concept is to take an example.

So imagine, that a stranger offers you food. Will you eat it? Most of you would say no, but the answer is, as you all know, depends on the location. Last week, for example, I went with my family to a temple and there was some other family out there who were doing a religious function and they did not know us, but they offered some prasad, and so we took it.

I and everyone in my family had it and did not have any issues taking it from a stranger because of the location. In the same context, if the same family had offered us food on a train, I would not have taken it and given it to my kids.

Of course, not. Why? Well, because there are several instances where people who were travelling got drugged due to being offered and consumed food from a stranger. So, as I mentioned earlier, location is of paramount importance here.

In the same way, let’s consider a head and shoulders pattern or a bullish engulfing pattern. Where is that pattern forming? Is it forming at the beginning or end of a trend? Is it forming after a 10% move on the upside or after the range? Hence the location of that pattern is very important.

If the location is not correct, the pattern will most likely be not reliable. Next time, when you look at a pattern and whichever pattern that might be, always pay attention to the location.

Now, the third reason why technical analysis fails is that we try to apply that on shorter timeframes. The one thing that you have to understand is that technical analysis, as a science, was developed, a hundred years ago.

During that time, these concepts were developed for a longer duration and people used to look at weekly and monthly charts. Daily charts used to be an exception because people used to like their trends in a bigger timeframe. However, if you play to apply the same concepts in a shorter timeframe such as intraday, what will happen is that most of the time, these patterns will not work.

This is again the most common complaint that I get. I’m looking at this pattern on an intraday chart and it looked like a double top or a double bottom, but it did not work. That is the problem we are talking about. If we are applying the concepts that were developed for much longer timeframes to a much shorter timeframe, what will happen eventually is these patterns will not work.

Hence it is not the fault of the pattern that is not working, but the timeframe that you are applying this concept.

The 4th reason why technical analysis sometimes fails is that we try to apply that on low liquidity stocks. You need to understand the fact that Technical analysis is a psychology of the masses.

We understand how people react when they are in profits and losses and their behaviour and that is what gives rise to these patterns. In the case of a certain stock where there are not enough people, there is no question of mass psychology coming into play and hence most likely these patterns will not work.

Therefore, if you’re looking for stocks, always go for the large caps. Mid-caps too are seldom fine, but stick with the large caps, index, commodities, forex or even cryptos, i.e. wherever you have sufficient liquidity.

However, if you try to apply technical analysis on a small-cap company or a penny stock, it will not work because there are not enough people trading that particular security for those patterns to be applicable. Hence the stock must have enough liquidity.

Now, the 5th reason why technical analysis can fail is because of our biases. I will give you an example. I was in the US for quite some time and I used to work for a company called Herbalife for about 5 years. I was engaged with a lot of projects for this company.

Hence I had a positive bias about the company and we also used to get employee stock options, which mean that we used to get shares from the company. My idea was to hold those shares for a long time, but, after a while, I left the company and joined another company. Here, I took some time to look back and decide whether it was a long-term investment from a stock perspective and not from the company’s perspective.

What I then realized was that even though I’ve worked with this company and the company was very good, it was not necessarily a great investment. That, again, is something I did not realize until I left my job and I joined a different company. These are the kinds of personal biases that we see a lot of time in our own life.

There are some companies that we like and what happens is that when you like something, your mind starts to identify patterns that may not necessarily be existing. So a bullish pattern may or may not be appearing or it may be in the process of appearing, but your mind wants to see something and it will force you to see that.

Bias can exist, because you are working for the company or maybe you were profitable trading that company for the first time. Hence, everybody has some kind of a favorite company or stock which he or she likes to hold on to.

My suggestion is that if you have a personal bias, look at that chart randomly and remove the name from the top and give this a go. Here is what I do. I have two screens and on one screen, I have all the stocks and on the other screen, I see the charts. What I do is I just scroll down from the other window without looking at exactly what stock’s chart I’m looking at and see what kind of patterns can I find right there.

I don’t know which company I’m looking at and that makes me unbiased. It also makes me think rationally without having any preconceived notions about the company. This is another strong, effective way of eliminating any personal biases concerning a certain stock or a company.

The 6th reason, unfortunately, why technical analysis sometimes fails is in the case of manipulated stocks. Stock manipulation has gone down substantially over the last two or three decades, but it is still happening and as we know, these things happen all the time. If you’re looking at a stock that is being manipulated by some operator, most likely it will not work on them.

Back in the 1990s, Harshad Mehta was pumping the stock of ACC. Whatever bearish, engulfing pattern that you saw on ACC, would not have worked because Harshad Mehta was just buying stocks with the money borrowed from all the banks.

How do you know whether the stock that you are looking at is being manipulated or not? Well, you don’t know, but, there is always a likelihood of manipulation happening in the business. The level of manipulation is very low because the amount of money required to manipulate those stocks is very high, but, again, it’s easy to manipulate penny and small-cap stocks.

It all comes down to liquidity and manipulation. If you stay away from the small caps and the penny stocks, then you will be fine. Stick to the large caps, with those sectors because it’s very hard to manipulate since they are large-cap companies.

Now, the last reason why technical analysis fails sometimes is because of the presence of new fundamental triggers. Now, what do I mean by that? For example, you are looking at a chart of a stock and you saw a bearish pattern and a head and shoulders pattern, which is indicating that the stock would come down.

A week after your analysis, something happens in the company. Let’s say the company is being acquired by a much bigger firm and now all of a sudden the stock, due to the positive sentiment starts to go higher. It is something that is happening in Zee Telefilms right now as we speak.

What happens is that your analysis was based on a certain set of data that the market knew then. Now the reality of the stock and the company has changed. If something like this happens, it’s not the fault of the technical analysis pattern that it did not work out.

It’s just that the information that has come to the market has changed the equation and the dynamics between the buyers and sellers. Hence, always keep in mind that if the stock is behaving very unexpectedly, maybe there is some fundamental news. There is some clear fundamental trigger in the stock, which is causing that to happen.

So these were the 7 reasons, which I believe that technical analysis fails. Not technical analysis per se, but the application of that analysis in real life.

I will give you 3 pointers that will help you apply technical analysis in real life.

Number one is that technical analysis has to be learned from the perspective of psychology. A lot of times what happens is that when we are looking at technical analysis, we see more patterns. If we want to see a certain chart pattern forming, it becomes mechanical. The reason technical analysis works simply put is that there is a psychology behind people who have money at stake.

If you understand your technical analysis, more from a psychology standpoint and a sociology standpoint, you will be in a better situation to understand what is going, not just in terms of the picture, but the emotions behind those patterns will become very clear.

The second recommendation, which is related to the first one is that, don’t be fixated with a certain picture in mind. You see something that you would want to see exactly happening. If you saw a certain pattern, you want to see exactly that, but in real life, it is not every pattern that you see in the books will appear the same.

The double top will not look exactly like a double top, the double bottom might not look like a double bottom and the head and shoulders will not look the same. Hence, you have to have flexibility in your mind and that’s the reason why the concepts are important rather than the exact picture. Be flexible because as a trader, you will never get perfect information on the charts and you need to see the noise, which is out there to identify the buttons.

My last suggestion is that technical analysis and trading, in general, is a game of probability. This is important to understand. You need to have a probabilistic mindset to learn technical analysis or to be able to trade profitably.

Why? This is because not everything will work every time. This is something you need to understand because what happens is that we saw something and this is something that we have learned in real life. If I saw something, it should work all the time, but that doesn’t work in trading.

You learn a concept and that concept is good. It is most likely to work for 60% or 70%. For the remaining 30% and 40%, your mind should be able to say that it did not work out this time and it is fine. Never look for something to be right and this is something which I learned.

If you don’t have that mindset of thinking in terms of probabilities, you most likely will even miss out on the concepts that work.

I hope that you will apply whatever I’ve shared with you in real life and benefit in some way, at least by not making some mistakes and hopefully profiting from that knowledge.