Handbook of Exchange Rates

12.5 The Future of Research on Technical Analysis

A major challenge for research on technical analysis is to produce a convincing theoretical underpinning for the voluminous empirical findings in the field. Some promising initial steps have already been taken in this direction. A number of competing behavioral models are able to reproduce some of the characteristics of currency markets, but it is important that these models be able to generate new predictions that can be tested. Burnside et al. (2011) is of particular interest in this regard. The authors construct a model in which overconfidence leads to overreaction to information about future inflation and provides an explanation for the forward premium puzzle and the profitability of carry trade strategies. Overconfidence can also be a source of momentum and trending in currency markets, suggesting that there may be a common underlying cause for the profitability of both TTRs and the carry trade strategy. Since their model predicts that the forward premium bias should be higher when momentum is high, we would expect to see a positive correlation between trading rule returns and carry trade profits.

An empirical challenge for technical analysis—one that has not been successfully met so far—would be to link order flow to technical trading signals and returns.¹⁶ An example of work linking order flow with technical analysis is Gradojevic (2007), who uses order flow as one input to a trading model that combines a neural network with ...