Intermediate Level

Learn more complex tools and techniques that will help you in trading.

Lesson 8: Technical Analysis

What is Technical Analysis?

Technical
analysis is a trading methodology used to analyze investment and locate trading
opportunities by examining statistical trends extracted from trading
activities, such as price movements and size. Unlike fundamental analysts who
attempt to analyze the importance of protection, technical analysts rely on market
movements trends, trading signals and various other quantitative graph
instruments to measure the strength or weakness of security.

Technical
analysis can be used for any protection with historical trading information. It
covers shares, options, commodities, fixed income, currencies and other
securities. In this tutorial, we typically discuss inventories in our examples,
but keep in mind that these principles can be extended to any kind of
protection. In addition, technical analysis is far more prevalent in commodity
and Forex markets where traders concentrate on short-term price movements.

The Fundamentals of Technical Analysis

Technical
analysts believe that past trading practices and adjustments in security rates
can be useful indicators of future price fluctuations in security. We may use
technical analysis independently of other research efforts or in conjunction
with some principles of intrinsic quality criteria, but most often their
convictions are based solely on numerical security graphs. The Market
Technicians Association (MTA) is one of the most popular groups assisting
technical analysts in their investments with the classification of Chartered
Market Technicians (CMT) as a common credential for many advanced technical
analysts.

The Underlying Assumptions of Technical
Analysis

There are
two main approaches used to analyze securities and to make investment
decisions: a fundamental analysis and a technical analysis. Fundamental
analysis includes an evaluation of the company’s financial statements in order
to assess the fair value of the business, while technical analysis assumes that
the protection price already represents all publicly available information and
relies instead on a statistical analysis of price movements. Technical analysis
seeks to understand the market sentiment behind price trends by looking for
patterns and trends rather than examining the fundamental attributes of
protection.

Charles
Dow has published a series of editorials on the philosophy of technical
analysis. His writings contained two basic assumptions that continued to form
the basis for the trading of technical analysis.

  1. Markets
    are efficient with values which represent factors that influence the price of
    protection, but;
  2. Market
    price fluctuations are not purely random, but pass on to known patterns and
    trends which appear to replicate over time.

The
Efficient Market Hypothesis (EMH) essentially means that the market price of
security at any given time accurately reflects all the information available,
and therefore represents the market price of security at any given time. This
hypothesis was based on the idea that the market price represents the total
knowledge of all market participants. While this presumption is generally
believed to be valid, it may be influenced by security news or events that may
have a varying short-term or long-term effect on security prices. Technical
analysis only works when markets are weakly responsive.

The second
basic assumption underlying the technical analysis, the idea that price changes
are not spontaneous, leads technical analysts to assume that market trends,
both short-term and long-term, can be established, enabling market traders to
benefit from investment based on a trend analysis.

Today,
technical analysis is based on three major assumptions:

1: Market discounts
on everything

Most
analysts condemn technical analysis because it only considers price movements
and ignores key factors. Technical analysts believe that everything from the
economics of a business to broad market indicators to consumer psychology is
already on the stock market. It removes the need to weigh the variables
separately before making an investment decision. The only thing left is the
study of price movements, which professional experts find to be the result of
supply and demand for a particular stock on the market.

2: Price movements in
patterns

Technical
analysts believe that markets are rising in the short, medium and long term. In
other words, stock prices are more likely to continue in the past than to shift
erratically. Most of the technical trading strategies are based on this
premise.

3: History tends to
repeat itself

Academic
experts believe that history tends to repeat itself. The repetitive nature of
price movements is often attributed to market psychology, which appears to be
very consistent based on emotions, such as anxiety and excitement. Technical
analysis uses chart patterns to examine these feelings and subsequent market
movements in order to understand trends. Although many methods of technical
analysis have been used for more than 100 years, they are still considered to
be important as they demonstrate trends in price movements that often repeat
themselves.

How technical analysis is used

Technical
analysis seeks to forecast price movements in almost any tradable commodity
that is typically subject to supply and demand powers, including stocks,
shares, futures and currency pairs. In addition, many views technical analysis
as simply studying the supply and demand forces as expressed in the market
price movements of protection. Technical analysis is most commonly applied to
price changes, but some analysts record numbers other than rates, such as
trading volumes or open interest figures.

Across the
industry, hundreds of patterns and signals have been produced by researchers to
help trade in technical analysis. Technical analysts have also developed a
number of forms of trading systems to help them forecast and trade price
changes. Many metrics focus primarily on defining the current market trend,
including support and resistance zones, while others concentrate on evaluating
the strength of the trend and the probability of its continuation. Commonly
used technical indicators and chart patterns include trends, streams, moving
averages and momentum indicators.

Generally
speaking, technical analysts look at the following broad types of indicators:

  • Price
    trends
  • Chart
    patterns
  • Volume
    and momentum indicators
  • Oscillators
  • Moving
    averages
  • Support
    and resistance levels

The Difference Between Technical Analysis
and Fundamental Analysis

Fundamental
analysis and technical analysis, major think tanks when it comes to approaching
markets, are at the opposite end. These approaches are used to analyze and
predict future developments in stock prices and, like any investment strategy
or theory, these their supporters and their opponents.

Fundamental
analysis is a method of analyzing securities by trying to measure the value of
the stock. Fundamental analysts research everything from the dynamics of the
overall economy and market to the financial condition and management of
companies. Earnings, investments, assets and liabilities are all key
characteristics of leading analysts.

Technical
analysis differs from fundamental analysis in that stock prices and volume are
the only outputs. The basic assumption is that all recognized fundamentals are
price-based; thus, there is no need to pay close attention to them. Technical
analysts do not attempt to measure the inherent value of the protection, but instead
use market charts to recognize patterns and trends that indicate what the
inventory will do in the future.

Limitations of technical analysis

The
biggest challenge to the validity of technical analysis is the economic
principle of an efficient market hypothesis. According to the EMH, market
prices already represent both current and past data, and so there is no way to
take advantage of trends or mispricing’s to make extra money, or alpha.
Economists and fundamental investors who believe in efficient markets do not
assume that any actionable information is found in historical price and volume
data, and that history does not repeat itself; rather prices move in a random
manner.

A second
critique of technical analysis is that it works in some situations, but only
because it is a self-fulfilling prophecy. For example, most technical traders
would position a stop-loss order below the 200-day moving average of a stock.
If a large number of traders have done so and the stock hits that level, there
will be a large number of orders to sell, which will force down the stock,
confirming the anticipated movement of traders.

Instead,
other traders will see the price decline and also sell their shares, increasing
the force of the phenomenon. This short-term selling pressure may be considered
self-fulfilling, but it will have no effect on where the asset’s value will be
weeks or months from now. In short, if enough people use the same signals, they
can trigger the signal to shift, but over a long period of time.