Technical Analysis

What is technical analysis?

Technical analysis is an approach to forecasting commodity prices that examines patterns of price change, rates of change, and changes in volume of trading and open interest, without regard to underlying fundamental market factors. Technical analysis can work consistently only if the theory that price movements are a Random Walk is incorrect. (Source: CFTC)

Technical analysis, also known as charting, is the study of the trading history (the price and volume over time) of any type of traded security (stocks, commodities, etc.) to attempt to predict future prices.

Technical analysis (studying the price and trading history) stands in contrast to fundamental analysis (studying the actual nature of the stock or commodity in question), although some investors combine the two types of analysis in making investment decisions.

Technical analysis is primarily (but not exclusively) conducted by studying charts of past price and trading action. Many different methods and tools are used in technical analysis, but they all rely on the assumption that price patterns and trends exist in markets, and that they can be identified and exploited.

Technical analysis is not, of course, 100% accurate, but attempts to give results that are, simply, correct more often than they are wrong.

Indeed, the central strategy of many active traders is to trade often, terminating trades that prove to be incorrect decisions and "letting run" trades that prove to be correct decisions.

Technical analysis is viewed by many as more art than science; a good proportion of technical and fundamental traders view the other side with derision. Furthermore, within technical analysis, adherents of different technical analyses (say candlestick charting and Dow Theory), often treat each other's approaches with derision.

Some academic studies conclude technical analysis has little, if any, predictive power while other studies show that the practice can produce excess returns. For example, measurable forms of technical analysis, such as non-linear prediction using neural networks, have been shown to occasionally produce statistically significant prediction results.

As an example of the debate regarding the efficacy of technical analysis, Peter Lynch, a very well-known and successful fundamental analyst, once commented, "Charts are great for predicting the past." A Federal Reserve working paper has shown that the statistical properties of intraday foreign exchange prices change near "support and resistance" lines, without showing that this result could be used in a profitable trading strategy.

Technical analysis (studying the price and trading history) stands in contrast to fundamental analysis (studying the actual nature of the stock or commodity in question), although some investors combine the two types of analysis in making investment decisions.

Technical analysis is primarily (but not exclusively) conducted by studying charts of past price and trading action. Many different methods and tools are used in technical analysis, but they all rely on the assumption that price patterns and trends exist in markets, and that they can be identified and exploited.

Technical analysis is not, of course, 100% accurate, but attempts to give results that are, simply, correct more often than they are wrong.

Indeed, the central strategy of many active traders is to trade often, terminating trades that prove to be incorrect decisions and "letting run" trades that prove to be correct decisions.

Technical analysis is viewed by many as more art than science; a good proportion of technical and fundamental traders view the other side with derision. Furthermore, within technical analysis, adherents of different technical analyses (say candlestick charting and Dow Theory), often treat each other's approaches with derision.

Some academic studies conclude technical analysis has little, if any, predictive power while other studies show that the practice can produce excess returns. For example, measurable forms of technical analysis, such as non-linear prediction using neural networks, have been shown to occasionally produce statistically significant prediction results.

As an example of the debate regarding the efficacy of technical analysis, Peter Lynch, a very well-known and successful fundamental analyst, once commented, "Charts are great for predicting the past." A Federal Reserve working paper has shown that the statistical properties of intraday foreign exchange prices change near "support and resistance" lines, without showing that this result could be used in a profitable trading strategy.

History

The premises of technical analysis were derived from observation of financial markets over hundreds of years. The oldest branch of technical analysis is the use of candlestick techniques by Japanese traders at least as early as the 18th century, and now one of the main charting techniques.

Traditionally, "Honno, the God of the markets," a very successful rice trader in early Japan, is said to have invented technical analysis.

Dow Theory, a theory based on the collected writings of Dow Jones co-founder and editor Charles Dow, inspired the use and development of technical analysis from the end of the 19th century. Modern technical analysis considers Dow Theory its cornerstone.

Technical tools and theories have been developed and enhanced in recent decades, with an increasing emphasis on computer-assisted techniques.

Technical analysis is not concerned with why a price is moving (e.g. poor earnings, difficult business environment, poor management, or other fundamentals) but rather whether it is moving in a particular direction or in a particular chart pattern. Technical analysts believe that profits can be made by "Trend following." In other words if a particular stock price is steadily rising (trending upward) then a technical analyst will look for opportunities to buy this stock.

Until the technical analyst is convinced this uptrend has reversed or ended, all else equal, he will continue to own this security. Additionally, technical analysts look for various price patterns to form on a price chart and will take positions in anticipation of the expected move following that pattern. The tools of technical analysis are believed to assist the technician in determining when trends have formed, ended, etc. and when particular patterns are unfolding.

For example, a popular technical analysis tool is a stock price's 200 day moving average. This is usually defined as the average closing price of a stock over the past 200 trading days (though there are many variations on the moving average used in technical analysis). A stock that has been trending higher will have a history of an increasing daily stock price and an increasing 200 day moving average. Though the daily stock price fluctuates (up 50 cents on day 1, down 20 cents on day 2, up 10 cents on day 3, etc.), the 200 day moving average changes much more slowly and traces a smooth curve that follows the current price on a chart.

When the 200 day moving average is violated by the daily stock price, a technical analyst uses this as strong evidence that a price trend has ended and that possibly a new one has begun to the opposite direction. Suppose IBM's 200 day moving average was 85 and the stock has been trending higher. If IBM closed at 84.50, then a technical analyst would consider selling his IBM holdings and perhaps selling short IBM because the perceived trend is ending.

The above example illustrates a few important characteristics and potential shortfalls of technical analysis. Much of technical analysis is art and open to some varying interpretation. One technical analyst might believe that IBM would need to trade below its moving average for two consecutive days before declaring its trend over. Another might say one day is adequate. To a technician a close below the 200 day moving average is always important, but two technicans might disagree on the best way to act. Still, it is safe to assume that both technicians expect to sell IBM.

The obvious problem in this example is: what if in the near term IBM climbs back above its 200 day moving average after the technician sells his stock? If the technical analyst follows his own rules then he might be buying stock back at a higher price than he just sold plus commissions. This is a substantial component of some of the criticisms of technical analysis. Technical analysis says "false signals" or "whipsaws" are an unavoidable part of using technical analysis. To a technical analyst, the costs of these whipsaws are far outweighed by catching a stock at the beginning of a new long term trend. Some research disputes this assertion however.

Technical analysis may be at odds with fundamental analysis. Fundamental analysis maintains that markets may misprice a security and, through various methods of fundamental analysis, the "correct" price can be calculated. Profits can be made by trading the mispriced security and then waiting for the market to recognize its "mistake" and reprice the security. In contrast, a technical analyst is not interested in a security's "correct" price, only in price movement.

Two well known sayings among technical analysts are, "The trend is your friend," and "Forget the fundamentals and follow the money." An example of the different views of technical and fundamental analysis follows. Suppose a stock was trading at 124.25 pence, and that the consensus fundamental analysis view of the stock was that it was worth 120.00 pence. If the share price rose to 125.00 pence, then to 126.00 pence, and then to 127.00 pence, a technical analyst would likely be a buyer of this stock in order to profit from the perceived trend. In contrast, a fundamental analyst would possibly look to sell the stock as it is moving away from what the fundamental analyst believes is the "correct" price. (Source: Wikipedia)

See also:
Charting and Chartists
Technical Analysis Blog Posts