Technical analysis is a method of evaluating securities by analyzing the statistics generated by market activity, such as past prices and volume. Technical analysts do not attempt to measure a security’s intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity.
Just as there are many investment styles on the fundamental side, there are also many different types of technical traders. Some rely on chart patterns; others use technical indicators and oscillators, and most use some combination of the two. In any case, technical analysts’ exclusive use of historical price and volume data is what separates them from their fundamental counterparts. Unlike fundamental analysts, technical analysts don’t care whether a stock is undervalued – the only thing that matters is a security’s past trading data and what information this data can provide about where the security might move in the future.
The field of technical analysis is based on three assumptions:
1. The market discounts everything
2. Price moves in trends
3. History tends to repeat itself
The Market Discounts Everything
A major criticism of technical analysis is that it only considers price movement, ignoring the fundamental factors of the company. However, technical analysis assumes that, at any given time, a stock’s price reflects everything that has or could affect the company – including fundamental factors. Technical analysts believe that the company’s fundamentals, along with broader economic factors and market psychology, are all priced into the stock, removing the need to actually consider these factors separately. This only leaves the analysis of price movement, which technical theory views as a product of the supply and demand for a particular stock in the market.
Price Moves in Trends
In technical analysis, price movements are believed to follow trends. This means that after a trend has been established, the future price movement is more likely to be in the same direction as the trend than to be against it. Most technical trading strategies are based on this assumption.
History Tends To Repeat Itself
Another important idea in technical analysis is that history tends to repeat itself, mainly in terms of price movement. The repetitive nature of price movements is attributed to market psychology; in other words, market participants tend to provide a consistent reaction to similar market stimuli over time. Technical analysis uses chart patterns to analyze market movements and understand trends. Although many of these charts have been used for more than 100 years, they are still believed to be relevant because they illustrate patterns in price movements that often repeat themselves.
Criticism of Technical Analysis
There are some who doubt the usefulness of technical analysis. After all, charts can tell us where the market has been, but why should they reveal where the market is going in the future?
Do you ever listen to the weather forecast in the morning to decide whether to take an umbrella to work? Isn‘t this just the same type of situation, using what has happened in the past to try to predict the future? Certainly, weather forecasts may be wrong, just as technical
analysis can be, but on the whole we consider them to be a good guide. Nothing accurately predicts the future, but it is perfectly acceptable in other fields to routinely infer by extrapolation what may happen in the future.
Fortunately, we also have evidence that the idea that you can‘t make a reasonable prediction of the future from past performance isn‘t true. In fact, when traders develop a system, or set of rules that they will use to tell them, when to trade, they will quite often ‗back test‘ them. This involves looking at what happened in the past, and seeing how the system would have performed over the years. The trader won‘t even use the system unless the back test shows that it would make consistent profits over time.
Incidentally, the field of statistics actually recognizes the difference between the two types of statistics. One is called descriptive statistics, which encompasses actual historical data, such as used in drawing the stock charts. The other is inductive statistics, where predictions are made on the basis of that data.
Another criticism that you may hear about technical analysis is that it is self-fulfilling, and has no real basis. The argument is that because traders all see the same signals, they trade so that the market moves in accordance with the overriding wisdom. Some analysts believe that charts are just for fun, BUT so many people join in the fun and believe in the charts that the fun becomes a reality in influencing the share price. That is why so many chartists take this seriously… When traders see what they consider to be a bullish pattern, then they all buy in the expectation of the market going up, which makes the market go up. On the other hand, if traders believe that a downtrend in price is about to start, of course they will sell the securities and everybody doing that will make the price go down.
At first sight, that sounds very convincing. No wonder the patterns work so well, if traders are forcing the markets in this way. But my first reaction to that idea is ‗So what?‘ – if the trading methods work, then we have the means to trade profitably! It shouldn‘t change us from using the patterns that work. That said, perhaps the idea deserves to be answered in more depth and possibly refuted.
For many years traders have studied chart patterns, and the main patterns which indicate favorable trades are certainly well known. However, to actually discern and identify any particular pattern requires some skill and interpretation, and because there can potentially be infinite variation in a stock chart there is always some question about which if any pattern is being exhibited. It is for this reason that many people assert that trading is as much an art as a science. This means that not all traders will consider the opportunity for a trade in the same way.
Consider, if everyone interpreted the market moves in a single unambiguous way, then everyone would be making a fortune. That‘s plainly not the case. They say that 90% of would-be traders fail and give up in the first six months. There‘s a lot more to trading, which you will be learning, than just looking for a few well-defined patterns.
Even amongst the traders who decided that the pattern was a tradable one, they would each bring their own interpretation to the opportunity. For instance, some would try to anticipate a potential reversal and trade early, while others would look for a definite move and then trade in the established direction of the trend. To some extent this would depend on the individual trader‘s style, and how aggressively they chose to trade. In the end, it finishes up as unlikely that there would be any trading taking place ‗en masse‘, but each would enter the market on their own terms.
As for trading being as much an art as a science, certainly there is a learning curve beyond scientific and mathematical analysis. There is a consensus of opinion that a novice trader must ‗pay their dues‘ in order to become skilled. This course will cut through the time needed for that by providing you with the lessons learned from experience.
Even if there was a self-fulfilling prophecy aspect to trading, any harm it did would be selfcorrecting. If things didn‘t work out for traders when they followed their chart patterns, then they would stop using them or change their tactics. The markets are really driven by supply
and demand, so traders‘ actions would only distort them temporarily.
You may have heard of the ‗pump and dump‘ strategy used by some opportunists. This is when someone identifies a sparsely traded stock of a small company, buys some stock, and creates a lot of publicity ‗talking up‘ the company‘s prospects in the near future. The flurry of activity amongst people who think the message is true can briefly change the prices, which is when the original shareholder ‗dumps‘ his shares for a profit.
The shares soon fall back to their true value. These tactics works to a limited extent, but only because the selected shares had hardly any buying and selling before, so any activity made the price overreact. To think that traders, acting on their own and without a specific stimulus like this, would be able to create a market move in any major stock is probably attributing too much power to the trading community.