Journal of International

Money and Finance (1992), 11, 304-314

The use of technical analysis in the foreign exchange market

MARK P. TAYLOR*

international Monetary Fund, Washington DC 20431, USA, City University Business School, London, UK, and Centre for Economic Policy Research, London, UK
AND HELEN

ALLEN

Bank of England, London, UK

Technical, or chart&, analysis of financial markets involves providing forecasts or trading advice on the basis of largely visual inspection of past prices, without regard to any underlying economic or fundamentalanalysis. This paper reports the results of a questionnaire survey, conducted on behalf
of the Bank of England, among chief foreign exchange dealers based in London in November 1988. Amongst other findings, it is revealed that at least 90 per cent of respondents place some weight on this form of non-fundamental analysis when forming views at one or more time horizons. There is also a skew towards reliance on technical, as opposed to fundamentalist, analysis at shorter horizons, which becomes steadily reversed as the length of horizon considered is increased. A very high proportion of chief dealers view technical and fundamental analysis as complementary forms of analysis and a substantial proportion suggest that technical advice may be self-fulfilling. (JEL F31)

Technical, or chartist, analysis of financial markets involves providing forecasts of asset prices or trading advice on the basis of visual examination of the past history of price movements (Edwards and Magee, 1967), perhaps with the aid of certain quantitative summary measures of past price movements such as momentum indicators (oscillators) or moving averages (Murphy, 1986), but without regard to any underlying economic, or fundamental, analysis. Keyness view that financial markets are likely to be dominated by nonfundamentals is well known.2 In the post-war period, financial economists *Any views expressed are those of the authors and are not necessarily those of the Bank of England or of the International Monetary Fund. The paper has been improved in the light of comments from an anonymous referee and from James Lothian, which the authors gratefully acknowledge. The authors have also benefited from conversations on this topic with Robert Shiller and with Lou Cordova. Responsibility for the present paper rests with the authors alone.
0261-5606/92/03/0304-11 0 1992 Butterworth-Heinemann Ltd

MARK P. TAYLOR AND HELEN ALLEN

305

have typically treated non-fundamentalist analysis of financial markets in general, and technical analysis in particular, with scepticism (see, e.g., Malkiel, 1985, chapter 5; Sharpe, 1985, chapter 19). In large part, this scepticism seems to have stemmed from the efficient markets hypothesis, a corollary of which is that speculators who do not concentrate on underlying economic fundamentals when making trading decisions will be quickly driven out of business by smart money.3 More recently, however, a number of researchers have begun to examine the role of non-fundamentalist analysis in financial markets. Frankel and Froot (1986, 1990), for example, suggest that technical analysis may have largely been responsible for the overvaluation of the US dollar during the 1980s at a time when the economic fundamentals would have suggested pressure in the opposite direction. A similar line of argument is developed by Goodhart (1988) and by Kirman ( 1991). In a similar fashion, some economists have suggested that technical analysis may have been an important contributory factor in the international stock market crash of 1987 (see, e.g., Shiller, 1989a, 1989b; Artis and Taylor, 1989). At a more general level, there now seems to be a growing interest in the role of traders in financial markets who do not use or who misperceive the fundamentals-noise traders (see, e.g., Shiller, 1984; Black, 1986; De Long et al., 1987; Campbell and Kyle, 1988). Recent empirical work based on survey data has also tended to bring into question the hypothesis that market practitioners utilize information rationally and efficiently in forming their expectations (Shiller, 1989a, 1989b; Taylor, 1988, 1989; Froot and Frankel, 1989), adding further impetus to the study of market non-fundamentals. Despite this growing professional interest in non-fundamental analysis, there seems to be little or no empirical evidence, other than anecdotal, on the prevalence and use of such techniques in financial markets.4 In November 1988, at the request of the Economics Division of the Bank of England, the present authors conducted a questionnaire survey on the use of technical analysis in foreign exchange trading in the London market.5 I. Questionnaire design The questionnaire was prepared after consultation with foreign exchange dealers at the Bank of England and at major London Banks as well as with the British Society of Technical Analysts. Its format was as follows.
Methods and sources of technical analysis

The first question asked which chartist methods and services were employed by the dealing room. Respondents were given a choice of three categories-analytical techniques (sub-divided into trend-following and non-trend-following techniques), computer analysis (sub-divided into graphics packages and online chartist computer services) and chartist publications.
The role of technical analysts

The next four questions asked whether the organization employed a particular chartist service or analyst and whether any in-house economists or technical

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Technical analysis in the foreign exchange market

analysts were employed. Information was also requested concerning whether in-house economists or technical analysts took trading positions or were employed in a purely advisory role.
Perceptions of the influence of technical analysis

The remainder of the questionnaire was designed to gauge the emphasis which market participants place on chartism and fundamental analysis over various time horizons and to ascertain whether the two approaches are viewed by practitioners as complementary or competing tools of analysis. In each case the response took the form of indicating a score on a scale from zero to ten. In the question concerning the emphasis placed on chart analysis by market practitioners at various horizons, for example, a score of zero would indicate the use of chart analysis alone at that horizon, a score of ten would indicate the use of pure fundamentals and an intermediate score would indicate a weighted mix of charts and fundamentals. Respondents were asked to provide this information for seven forecasting horizons-intraday, one week, one month, three months, six months, one year and beyond one year. Alternatively, respondents could also indicate that no view was officially taken over the particular horizon. In the question concerning complementarity, a score of ten implied a view that the two approaches are mutually exclusive, a score of zero implied a view that they are strongly complementary and an intermediate score an intermediate degree of complementarity. Finally, respondents were invited to add any general comments which they thought relevant concerning the role and use of technical analysis in the foreign exchange market. II. Coverage and results A strong attempt was made to send out the questionnaire to every chief foreign exchange dealer operating from an active dealing room in London. The mailing list was compiled with the assistance of the Banking Supervision Department of the Bank of England. The institutions approached were thus largely those banks which report regularly to the Bank of England in respect of foreign exchange exposures. In addition, other institutions listed by the Bank of England under Section 43 of the United Kingdom 1986 Financial Services Act as market makers in foreign exchange were also included. While the original mailing list had 402 named institutions, 16 were returned to sender by the Post Office (presumably because the institutions had closed or moved) and 33 were returned, marked by the institutions as being inapplicable as they had no active dealing arm. A total of 213 fully completed questionnaires were returned, which as a percentage of 353 ( =402-16-33) gives a response rate of over 60 per cent.j Tables 1 to 4 contain a detailed breakdown of the results of the survey. The responses to questions concerning which chartist techniques and sources of chartist advice were most used in practice revealed that by far the most widespread source of technical advice among the respondents was in the form of online chartist computer services (Table 1). Nearly 36 per cent of respondents reported using chartist computer graphics packages while some 65 per cent reported using online commercial computer services. The results also indicated the widespread use of technical indicators such as moving averages and other

MARK

P. TAYLOR AND HELEN ALLEN methods chartist and services. methods and services does your

307

TABLE1. Chart& Question: Which organization use? of the following

% Yes (A) Analytical techniques Moving averages and/or other trend-following systems Oscillators, momentum lines and/or rate of change indicators (B) Computer graphics and services Chartist graphics packages Online chartist (C) Chartist Question: analyst? computer services

% No

% No response

64.3 40.0

34.7 59.0

1.0 1.0

35.6 64.8 41.8 use a particular % Yes 21.1

59.2 34.7 54.9 chart % No 78.4 company

5.2 5.2 3.3 or chart

publications

Does your organization

% No response 0.5

TABLE2. Employment Question:

and role of technical employ % No 61.5 employ % No 75.1

analysts

and economists. economists? % No response 0.0

Does your organization

any in-house

% Yes 38.5 Question: Does your organization

any in-house

technical

analysts?

% Yes 24.9

% No response 0.0

Question: If economists are employed in-house, do they take trading positions in foreign exchange or is their role purely advisory?* % Take positions 38.5 % Purely advisory 61.5 % No response 0.0

Question: If technical analysts are employed in-house, do they take trading positions in foreign exchange or is their role purely advisory?** % Take positions 45.3 % Purely advisory 34.0 % No response 20.7

*Figures calculated as percentage of those replying that they employed in-house economists. **Figures calculated as percentage of those replying that they employed in-house technical analysts.

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Technical analysis in the foreign exchange market

trend-following indicators-over 64 per cent-and non-trend-following systems such as momentum indicators or oscillators (Murphy, 1986)-40 per cent. Additionally, some 21 per cent of respondents relied on advice from outside commercial chartist organizations for technical analysis, while some 42 per cent subscribed to chartist publications. Responses to further enquiries concerning sources of exchange rate advice are summarized in Table 2. They reveal that almost exactly a quarter of respondents reported that their organization employs in-house technical analysts, as opposed to 38 per cent who reported employing economists in-house. There is also some evidence that more chart analysts took trading positions than economists (Table 2). One of the clearest results of the questionnaire survey was that chart analysis appears to exercise its greatest influence when dealers are formulating forecasts

TABLE

3. Relative importance

of technical

versus fundamental

analysis.

Question: Please indicate chartist/technical analysis forecasting horizons (A) Percentage

on the following scale the relative importance you attach to versus fundamental analysis of currencies over the following

response for each point on the scale* SCALE: 0 = pure chartism to 10 = pure fundamental 0 5.6 1.8 2.0 1.6 1.8 2.4 3.5 1 3.4 2.5 0.0 0.8 1.8 1.2 1.8 2 15.6 4.9 1.3 1.6 0.9 1.2 3.5 3 13.4 13.5 6.7 2.4 1.8 1.2 0.0 4 6.7 18.4 15.4 8.8 5.5 1.2 0.0 5 15.6 20.2 16.8 21.6 12.8 9.6 3.5 6 8.4 11.0 17.4 9.6 14.7 4.8 7.0 7

analysis 8 7.3 4.3 7.4 15.2 16.5 18.1 17.5 9 2.8 3.1 8.1 6.4 7.3 21.7 15.8 10 10.6 9.2 12.1 13.6 18.3 20.5 33.3

Horizon Intraday 1 week 1 month 3 months 6 months 1 year Longer than 1 year

10.6 11.0 12.8 18.4 18.3 18.1 14.0

(B) Percentage of total number of respondents who marked the scale at each horizon and percentage who stated that they did not take a view at a particular horizon % Taking no view % No response % which marked scale Intraday 1 week 1 month 3 months 6 months 1 year Longer than 1 year 84.0 76.5 70.0 58.7 51.1 39.0 26.8 8.9 18.8 24.9 35.7 44.2 55.4 66.7 7.1 4.7 5.1 5.6 4.7 5.6 6.5

*As

percentage of total number who marked the scale at the relevant horizon (see

B).

MARK

P. TAYLOR AND HELEN ALLEN

28 t 24 20 00 16 12 a 4 0 One to three months forecasting

309

28 t 24 20 do 16 12 a 4 0

lntraday

to one

week

forecasting

_
28 24 20 16 op 12 a 4 0 0 1 2 3 4 5 6 7 a 9 10 Six months to one year forecasting

b
2a 24 20 @0 16 12 a 4 0 One year or longer forecasting

12

910

FIGURE 1. Relative emphasis placed on charts versus fundamentals. The figure shows the percentage of respondents advocating a particular charts/fundamentals weighting at each time horizon. On the horizontal scale, 0 = pure charts, 10 = pure fundamentals.

or trading decisions concerning relatively short time horizons. This is evident from the results summarized in Table 3 and presented visually (for four summary horizons) in Figure 1. At the shortest horizons (intraday to one week), approximately 90 per cent of respondents reported using some chartist input when forming their exchange rate expectations, with 60 per cent judging charts to be at least as important as fundamentals (Figure la). At longer forecast horizons of one to three months or six months to one year, the weight given to fundamentals increases (Figures lb, lc). At the longest forecast horizons of one year or longer, the skew towards fundamentals is most pronounced (Figure Id), with around a third of respondents relying on pure fundamentals and some 85 per cent judging fundamentals to be more important than charts. It can, however, be seen from Figure 1 that there is a persistent 2 per cent or so of respondents who apparently never use fundamental analysis at any horizon. With regard to the question concering the complementarity of chartist and fundamentalist approaches, only 8 per cent replied that they considered the two approaches to be competing to the point of being mutually exclusive; the rest held them to be complementary to a greater or lesser degree (Figure 2). A detailed breakdown to the responses to this question is given in Table 4. The view that chartist and fundamentalist analysis is largely complementary also figured strongly in respondents general comments, as did the related view that charts should be used to confirm but not contradict the message from the

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15 I-

Technical analysis in the foreign exchange market

10

FIGURE 2. The perceived complementarity of technical and fundamentalist analysis. The figure shows the percentage of respondents advocating a particular degree of complementarity between technical and fundamentalist analysis of foreign exchange markets. On the horizontal scale, 0 = strongly complementary, 10 = mutually exclusive.

TABLE 4.

Perceived complementarity

of technical and fundamental

analysis.

Question: Please indicate on the following scale the degree to which you view chartist/technical analysis and fundamental analysis to be complementary tools of analysis in foreign exchange trading* Scale: 0 = strongly complementary to 10 = mutually exclusive 0 Percentage 13.6 1 10.7 2 14.6 3 13.1 4 13.6 5 12.6 6 2.9 7 7.8 8 3.9 9 0.0 10 7.3

* Percentage calculated as percentage of total number of respondents who expressed a view, i.e.,206; seven respondents gave no response to this question.

fundamentals.

One respondent in particular went into some detail on this issue:

A classic attitude on the interbank side is if I agree with the technical view Ill double my position-if I disagree Ill throw it in the bin. On the customer dealing side [dealers] typically use it to complement their own fundamental view. Good fundamental arguments, for instance, would be put forward for why sterling should fall. The customer will then invariably ask by how much? Often, technical analysis is used to provide this sort of quantitative level of a fundamental view.

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311

Other comments explicitly highlighted the time horizon being considered:

the complementarity

issue, linking it to

Although fundamentals are the major factor when determining long-dated views and positions, charts do have an advantage when determining shorter periods and currencies. Although effective in indicating trend changes and highlighting trading opportunities, charts remain an indicator only and are

used as a confirmation of views/positions rather than as a trading vehicle on their own. Over the medium term, i.e., six months+, technical analysis is of dubious importance. Intraday, the relative strength or features of a move are more visible if one uses charts. In the long term, fundamentals will rule. But in the short term, chartists will lead because dealers need a lead of some sort to base opinions/views on. Several comments made by survey participants indicated a belief that charts essentially measure swings in market psychology, which may be of most importance in the shorter term but may be harder to forecast over longer horizons. A slightly different view expressed by several respondents was that chartism may actually obscure the underlying fundamentals over the shorter horizons; for example:
. . . charts merely prevent fundamentals coming through over the short term. The skill therefore is to spot when the charts will break down and catch up with the fundamentals. As a trading tool they are useful because they are widely used and therefore can be self-fulfilling.

Such a view seems to be tantamount to asserting that the use of technical analysis by dealers may have the effect of generating mean-reverting excursions from the fundamentals-i.e., fads (Poterba and Summers, 1988). Another recurring theme among respondents general comments, also evident in the last quotation, was that chart analysis may be largely self-fulfilling, with some 40 per cent stating so explicitly. One respondent wrote: Knowledge of chart signals is essential to all operators as they have a bearing on the action of many market participants . . . This holds true both for operators who place high priority on technical analysis and for others-like ourselves-who prefer a more fundamental approach. This quotation, and several others like it among the responses, tends to support the suggestion of De Long et al. that sophisticated speculators will not trade purely on consideration of the economic fundamentals, but will also aim to exploit market movements generated by less sophisticated, noise traders (De Long et al., 1987, p. 2). III. Concluding remarks This paper has summarized the results of a questionnaire survey on technical analysis sent widely to chief foreign exchange dealers based in London. Among the various findings discussed above, we would wish to highlight the following. A particularly striking finding of the research is that at least 90 per cent of survey respondents reported placing some weight on technical advice when

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Technical analysis in theforeign exchange market

forming their exchange rate expectations over one or more of the forecast horizons considered. There also seems to be, however, a clear consensus among respondents that chart analysis is used mainly as a guide to shorter-term exchange rate behavior and, moreover, that chartist advice should be used in conjunction with fundamentalist advice. The behavior of the major exchange rates during the recent floating period has provided a number of puzzles, including the very high volatility of real exchange rates (Dornbusch, 1987), the ability of exchange rates apparently to defy economic fundamentals over protracted periods of time (Frankel and Froot, 1986,1990), the poor performance of empirical exchange rate models (Meese and Rogoff, 1983; MacDonald and Taylor, 1991) and the apparent rejection of the efficient markets hypothesis as applied to the foreign exchange market (Hodrick, 1987; Frankel and Froot, 1987; MacDonald and Taylor, 1991). One interpretation of the evidence reported in this paper is that at least some of these puzzles may eventually be resolved by attempting to understand the interaction between fundamental and non-fundamental forces in the foreign exchange market.* Another interpretation might be that the world is far more complex than existing economic models of the foreign exchange market allow. For example, if the structure of financial markets is inherently non-linear then fundamentalists may lose credibility in the market place when there are large price movements and their linear forecasting models cease to provide good local approximations to price behavior. Meanwhile, technical analysts, by working very closely with the minutiae of market movements, are able to get a good intuitive feel for a closer local approximation to the underlying economic structure and thus gain popularity with traders whilst having no deep understanding of market forces-in the same way that a good billiards player may have no knowledge of physics. On the other hand, the evidence reported above that there appears to be increasing reliance of traders on fundamentalist analysis as the forecast horizon is extended suggests that models based on economic reasoning will ultimately be preferred. While the laws of physics-at least those relevant for terrestrial billiards playing-remain constant and well-defined however, those governing financial markets remain to a large extent mysterious. Finding tractable models of exchange rate behavior which can explain past exchange rate movements, predict future exchange rate movements with some degree of accuracy and explain (or, at least, allow for) the popularity of technical analysts remains a very real challenge of international financial economics.

Notes 1. The terms technical and chartist and their derivatives are used interchangeably throughout the paper-as they were in the questionnaire survey. Questionnaire respondents were advised of this usage. 2. Keyness beauty contest analogy of the stock market, as discussed in the General Theory is probably the most famous exposition of this view: Investment based on genuine long-term expectation is so difficult.. . as to be scarcely practicable. He who attempts it must surely run greater risks than he who tries to guess better than the crowd how the crowd will behave (Keynes, 1936). Keynes also stresses the importance of animal spirits in financial markets in the Ilieatise on Money (Keynes, 1930): .. . the vast majority of those who are

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313

3. 4. 5.

6.

7. 8. 9.

concerned with the buying and selling of securities know almost nothing whatever about what they are doing. They do not possess even the rudiments of what is required for a valid judgment, and are the prey of hopes and fears easily aroused by transient events and as easily dispelled. This is one of the odd characteristics of the capitalist system under which we live, which, when we are dealing with the real world, is not to be overlooked. Such a view, for example, underlies Friedmans ( 1953) apologia offloatingexchange rates. Goodman (1980) provides some evidence on the performance of technical analysts, but not on the importance which the market attaches to such advice. Concentration on the London foreign exchange market was considered justified first on grounds of practicability and secondly on grounds of the pre-eminence of the London market and the high proportion of international dealing institutions operating from London. Surveys of turnover conducted by some 20 central banks in April 1989 revealed that London continues to be the largest foreign exchange market, with an estimated daily turnover of $187 billion, compared to estimated daily turnovers of $129 billion and $115 billion in New York and Tokyo, respectively (Switzerland, Singapore, and Hong Kong were the next largest markets, with estimated daily turnovers of $57 billion, $55 billion, and $49 billion, respectively-Bank of England, 1989). In addition, non-British institutions accounted for some 80 per cent of aggregate foreign exchange turnover in London, of which 39 per cent was accounted for by North American principals and 11 per cent by Japanese principals (ibid.). The true response rate is in fact likely to be even higher as some of the institutions to which the questionnaire was sent but not returned from may also have closed, moved, or may not have had an active foreign exchange dealing room. Because of undertakings of confidentiality made by the Bank of England, particular firms, analysts or services cannot be named. Frankel and Froot (1986, 1990) and Kit-man (1991) are examples of research which has begun to take this approach. MacDonald and Taylor (1991) provide a discussion of new approaches being followed in exchange rate research.

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