Technical Analysis - Explained
What is Technical Analysis?
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Table of ContentsWhat is Technical Analysis?How Does Technical Analysis Work?Technical Analysis BasicsPrinciples of Technical Analysis
What is Technical Analysis?
Technical analysis is a method of evaluation employed in the field of finance to forecast future price movement of a security based on an examination of past price movements. Technical analysis thoroughly inspects trading activity of securities in order to identify market trends such as price movement patterns, trading signals and changes in volume. Any security that offers historical trading data stocks, futures, commodities, fixed-income, currencies, and other securities can be subjected to technical analysis. However, it is important to note that technical analysis vastly differs from fundamental analysis, which is more focused on the evaluation of the intrinsic value of securities.
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How Does Technical Analysis Work?
Although technical analysis is applicable to practically any type of security, it is most widely used in the commodity and forex markets. This is because short-term price movements form the focal point in trading in both of these markets. A wide array of market indicators are employed by technical analysts in order to ascertain if an asset is trending, and if it is, the probability of its direction as well as of its continuation. These market indicators include up and down volume, and advance and decline data, in addition to other inputs. Technical analysis is also used to establish correlations between price/volume indices and market indicators. Examples of such indicators include the moving average, relative strength index, and moving average convergence/divergence (MACD). Moreover, technical analysis is also used to study relationships between changes in options and put/call ratios with price.
Technical Analysis Basics
Charles Dow, the co-founder of Dow Jones, introduced the present iteration of technical analysis in his Dow Theory during the later part of the 19th century. His research work was further reinforced by the efforts of other eminent researchers such as William P. Hamilton, Robert Rhea, Edson Gould and John Magee, who significantly contributed to the evolution of the Dow Theory. At the core of technical analysis is the consideration that future financial price movements can be forecasted on the basis of an examination of past price movements. In this regard, technical analysis is comparable to weather forecasting which relies on the application of science and technology to predict weather conditions for a particular location at a particular point of time. Having said that, both technical analysis and weather forecasting share a common disadvantage and that is forecasting inaccuracy. Technical analysis does not lay claim to absolute predictions, but instead presents a likely scenario of price movements over time. Therefore, it is not uncommon for technical analysts to employ technical analysis in combination with other concepts in an effort to achieve more accurate predictions with respect to prices of securities.
Principles of Technical Analysis
Presently, there are three underlying principles of technical analysis. They are:
- The market action discounts everything: Technical analysis assumes that prices reflect all pertinent information such as market psychology, broad market factors as well as the fundamentals of any particular company. As such, it is important to be able to comprehend investors opinions both known as well as perceived about such information. However, technical analysis has also been at the receiving end of criticism because of its blatant disregard for fundamental factors and an overreliance on price movements.
- Prices always move in trends: Technical analysis assumes that prices move in directional trends prices can move up or down, stay flat (also known as sideways movement) or move in a combination of these directions. According to Charles Dow, each trend is made up of three parts (i) Primary trends that are comparable to tides, which keep moving further inland until they reach the farthest point, (ii) Secondary trends that are comparable to waves and reflect corrections to the primary trend, and (iii) Minor trends, or ripples that represent fluctuations in the secondary trends. In terms of duration, price trends can be classified as (1) short-term trends, that occur over a few hours or days (2) intermediate trends, that typically last from a few weeks up to six months, and (3) long-term trends that occur over one year up to several years, and are the most difficult to predict. Technical analysts believe that a stock price is much more likely to follow a past trend than behave erratically, and this assumption forms the basis of a majority of trading strategies.
- History tends to repeat itself: Technical analysis assumes that history tends to repeat itself. According to technical analysts, market psychology is the principal force that engenders repetitive price movements as well as recurrent investor behavior. As such, surveys of investor sentiment in bearish or bullish market situations are often used by technical analysts to determine future directions of market trends. While bullish markets usually instil a sense of excitement in investors, bearish markets situations often lead to feelings of fear and apprehension.
It is important to note that the principles of technical analysis can only be applied to those securities the prices of which are influenced solely by the market forces of supply and demand. When other forces come into play in influencing the price movement of a security, technical analysis is no longer viable.