Methodical Madness: Technical Analysis and the Irrationality of Exchange‐rate Forecasts

Substantial empirical research documents that exchange‐rate forecasts are not formed rationally. This paper identifies a common technical trading signal, the head‐and‐shoulders pattern, as a potential source of departures from rationality in exchange‐rate forecasts. Forecasts based on this pattern are evaluated for daily dollar exchange rates over 1973 to 1994, using two criteria for rationality: profitability and efficiency. Resulting profits, replicable in real‐time, are tested for statistical significance using a bootstrap technique. We find that the rule is profitable, but not efficient, since it is dominated by simpler trading rules.