Technical analysis is one of the most popular technique used by traders in the ForEx market. One of the most important questions traders desiere to find an answer to is the following: does technical analysis grand higher returns to them? Empirical evidence shows that it grants higher returns than the fundamental analysis at short horizons. These findings have been confirmed to hold in many markets. Many researchers have demonstrated that technical strategies generate excess returns over a long period during the 1970s and 1980s. With a difference. The excess returns generated by simple technical rules based on filters or moving averages had disappeared by the early 1990s, but those granted by more complex rules still persist.
In a study by Neely and Weller (2012) the authors have tested several hypotheses that the technical analysis textbooks has suggested to justify higher income. The researcher ruled out data mining as an explanation for the early profitability of technical rules. Both out-of-sample analysis and adjustments to statistical tests indicate that the returns were true.
Nevertheless, there could be another possible explanation which can justify excess returns, related to the intervention operations undertaken by central banks, when they target for the exchange rate that differs from its fundamental value. These operations may allow traders to gain, if they adopt the right strategy. In particular, assuming that central banks follow a “leaning against the wind” attitude, then exchange rate trends become more predictable and can be detected by technical analysis.
However, research using high-frequency data has shown that the periods of greatest profitability precede central bank interventions. In other words, central banks intervene to stem strong trends in the exchange rate, not the vice versa.
A proliferation of behavioral models can reproduce the trending seen in ForEx markets and show that trading based on technical analysis can be consistently profitable in certain circumstances. The adaptive market hypothesis provides a promising framework in which higher returns can be justified. Behavioral decision rules that depart from the standard paradigm of investors’ rationality, and evolutionary selection mechanisms, could also provide possible explanations.