This article is written by @devinnath from InvestingNote. Devin is a technical analyst who balances FA and TA in his investment decisions. He believes in using news and FA to spot the right stocks and rely on TA to give him the lowest risk-to-reward ratio possible.
In the last post of the TA series, most of you are puzzled by the million dollar question of “Why does TA work?” Most people think that It seems too good to be true if you can actually look into the future just by using some mathematical formula and charts, isn’t it? I too believe that you might have been told by someone, somewhere that in the investment universe, if it is too good to be true, then it is indeed too good to be true. Unfortunately, in TA world not everything is always full of sunshine and rainbow.
Then why does TA still work? Thanks to the experience of all the seasoned investors over the centuries, they have drawn up fundamental assumptions of the market. These assumptions of the market actually form the foundation that enables TA to work.
To put it simply, these are the 3 main assumptions of the market that all seasoned technical analyst know, and you should too:
The market is efficient enough to account for everything
One major criticism of TA is that it completely ignores fundamental factors of a company, currency, psychology, etc. However, a counter argument would be the Efficient Market Hypothesis (Investopedia.com), where it assumes that the market is already efficient enough to discount everything. This means that the different factors which are perceived to affect stock price such as company’s balance sheet, cash flows, income statement, currency, psychology, etc has been factored into the stock’s price.
This leaves us with price movement, which can be accounted by the TA.
However, as most of us know that even the most advanced markets are not perfectly efficient due to the imperfect and asymmetric information. This causes drawback to the accuracy of TA. That is when stop loss comes in to help us mitigate the trading risk.