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Technical analysis: an obstinate passion

Technical analysis – which predicts future asset price movements on the basis of their past movements – is widely used in the foreign exchange markets. In a forthcoming survey, Lukas Menkhoff and Mark P. Taylor try to find a rationale for a practice that has long perplexed academic researchers but which can prove to be profitable. 

forex.jpgFor many professional financial economists, the widespread and continuing use of technical analysis – or, as it sometimes called, "chartist analysis" – in the foreign exchange market is somewhat puzzling. These techniques eschew scrutiny of economic fundamentals, relying only on information about past exchange rate movements. According to even the weakest notion of market efficiency, such data should already be embedded in the current exchange rate. 

The widespread use of technical analysis by foreign exchange professionals was first brought to the attention of academic researchers during the 1980s. But it has been during the last 15 years or so – beginning with joint research by Mark P. Taylor and Helen Allen (1990, 1992) – that a number of studies have reported the results of surveys of foreign exchange market participants in the major trading centres concerning the use of technical analysis. 

These studies suggest both that technical analysis is in widespread use among foreign exchange professionals and that significant profits can be and are being made using these techniques. How can this be explained? 

Technical analysis can best be seen as an instrument for informing traders about "market sentiment"

One argument is that the use of technical analysis is an indication of behaviour that is not fully rational. This view is difficult to reconcile with the fact that virtually all professionals in the market rely on the tool at least to a small degree. 

Another view relates the profitability of technical analysis to foreign exchange interventions by the monetary authorities. But recent evidence suggests that by driving the exchange rate away from the level consistent with the fundamentals, it is the other way round: the influence of technical analysis may in fact generate a rationale for official intervention. 

A third position – namely that technical analysis is simply an instrument in the processing and assimilation of market information – can also reconcile the importance of market order flows and technical analysis to some degree. The main problem with this position, however, is that it does not explain the reason behind such market phenomena as sluggish adjustment to news and traders’ preferences for round figures when placing orders. 

Overall, therefore, perhaps the most satisfying explanation for the continued use of technical analysis seems to be a fourth position, whereby technical analysis is seen as an instrument for informing traders about non-fundamental determinants of prices – what might be collectively described as "market sentiment." 

Technical trading strategies should be constantly evaluated as potential tools in the search for excess returns

These forces are more important in the shorter run. So for a full understanding of exchange rate dynamics, professionals need a combination of several tools encompassing both technical and fundamental analysis. 

What is perhaps most striking from our reading of the research literature is that technical analysis remains a passionate obsession of many foreign exchange market professionals. It is clearly an intrinsic part of this market. 

For academic researchers, this means that it must be understood and integrated into economic reasoning at both the macroeconomic and the microstructural levels. For market practitioners, it means that technical trading strategies should be constantly evaluated as potentially important tools in the search for excess returns. 

Publication Details
The Authors
  • Lukas Menkhoff is professor of economics at the University of Hannover.
  • Mark P. Taylor is professor of macroeconomics and international finance at the University of Warwick, and a research fellow of the Centre for Economic Policy Research. He is also a managing director of Barclays Global Investors, where he works on international active asset allocation strategies. 
Further reading
  • Allen, Helen, and Mark P. Taylor. 1990. "Charts, Noise and Fundamentals in the London Foreign Exchange Market." Economic Journal 100 (supplement): 49-59. 
  • Taylor, Mark P., and Helen Allen. 1992. "The Use of Technical Analysis in the Foreign Exchange Market." Journal of International Money and Finance 11: 304-14.