The profitability of technical analysis has always been one of the hot topic in the history of trading. Are trading rules really profitable in forex markets? Can they truly beat fundamental analysis? By taking a look at the empirical evidence, this show that technical indicators dominate fundamental analysis-based trading, at short horizons. Researchers have demonstrated that technical trading rules were able to generate excess returns during the 1970s and 1980s and that the excess returns to more complex or sophisticated rules than moving averages have persisted.
Christopher J. Neely and Paul A. Weller (Federal Reserve Bank of Saint Luis), in their paper ‘Technical Analysis in the Foreign Exchange Market’ have tested several theoretical hypotheses to explain forex trading profitability and concluded that adjustments to statistical tests indicate that the returns were genuine. Another possible explanation refers to the intervention operations of the central bank. If the central bank has a target for the exchange rate that differs from its fundamental value, then intervention may allow traders to profit at the expense of the bank. In particular, if the central bank follows a strategy of “leaning against the wind,” according to the two researchers, then this may create predictable trends in the exchange rate that can be detected by technical indicators. However, research using high-frequency data has shown that the periods of greatest profitability precede central bank interventions. In other words, central banks have intervened to stem strong trends in the exchange rate, from which technical rules happen to profit.
Therefore, central banks’ intervention has been correlated with periods of high profitability for technical rules. Also behavioral models which reproduce forex trading show that technical trading can be consistently profitable in certain circumstances. The adaptive market hypothesis provides a promising framework in which such models can be further developed. Its emphasis on behavioral decision rules that depart from the standard rational paradigm, and on learning and evolutionary selection mechanisms, indicates a shift in focus also in forex markets.