Defining Technical Analysis

Defining Technical Analysis

What is Technical Analysis?

Technical Analysis is a trading discipline used to assess investments and determine trading opportunities. This is achieved by analyzing statistical trends of the trading activity, such as volume and price movement. 

Technical Analysis is used to assess security with historical trading data. Security is a tradable financial asset. This definition encompasses stocks, commodities, currencies, futures, fixed-income, and other financial assets. In this session, shares will be examined, but these concepts are applicable to any security or financial asset. This must be kept in mind by any trader. Technical analysis is more commonly used in forex markets and commodities where some traders keep an eye on short-term price fluctuations. 

Fundamental Analysts vs. Technical Analysts

Fundamental analysts assess a security’s intrinsic value while Technical analysts evaluate patterns of price movements, trading signals, and other charting tools to evaluate a security’s strength or weakness.

Origins of Technical Analysis

Technical analysis was first introduced by Charles Dow and the Dow Theory in the late 1800s. Some of the remarkable researchers who contributed to it were Robert Rhea, John Magee, William Hamilton, and Edson Gould. The accumulation of these researches led to the basis of the Dow Theory. Now technical analysis has developed to include more than a hundred patterns and signals. This was achieved through years of continual research.

Technical analysts believe that price fluctuations of security in the past can be used to determine its movements in the future. Analysts sometimes use technical analysis without additional concepts; however, in some cases, they combine it with other ideas to analyze the trends. The Market Technicians Association (MTA) is one of the most popular groups that support technical analysis traders in their investments in the Chartered Market Technicians (CMT).

The Underlying Assumptions of Technical Analysis

The two primary trading disciplines used to analyze securities or trading assets: fundamental analysis and technical analysis. In the paragraph above, the difference between the two was already addressed. However, this will be explained further.

Fundamental analysis takes a company’s financial statements to determine its fair value. It usually bases on a security’s intrinsic value or primary attributes. Fundamental analysis analyzes everything from the overall economy and industry conditions to financial conditions and company management. It takes expenses, earnings, liabilities, and assets into consideration.

On the other hand, technical analysis strictly focuses on statistics and price fluctuations. It attempts to analyze the market by checking patterns and trends. It has an assumption that all fundamentals of security are factored into the price. It does not measure the intrinsic value of a security, instead the stock charts to determine the patterns and trends which is believed to forecast its future movements.

Charles Dow released editorials that discussed his theory on technical analysis. In his writings, two basic assumptions are formulated which still form the basis of technical analysis.

1. A security’s price is influenced by factors represented by values, which makes the market efficient.

The Efficient Market Hypothesis (EMH) states that the price of a security in a given time is an accurate representation of its actual value as it reflects all its available information. This first assumption states that the price of a security is a reflection of the total knowledge of all participants in the market. Even when this assumption is generally taken to be accurate, it does not take the fact that some factors could affect the market price, such as news or market announcements that may change the course of short-term and long-term trends. Technical analysis works most when the market is weakly efficient.

2. Price fluctuations move in patterns and trends that usually repeat; it does not move in random.

This second assumption states that short-term and long-term market trends can be identified, which gives the notion that traders can profit from trading in the market if they base on trend analyses. 

Now, the technical analysis presents three underlying assumptions:

1. Market discounts

The main criticism of technical analysis is the fact that it does not consider the fundamental factors of security and only notes the price movements. Technical analysts think that there is no longer the need to review primary market factors separately as these already affect the market price of a security in the first place. 

2. The trend of Price Movements

Technical analysts believe that rates fluctuate in short-, medium-, and long-term trends. They believe that a stock price is most likely to go on with a continuing trend than to move erratically.

3. Trend Repetition

Technical analysts believe that the price movements reflect market psychology. It is predictable as market movements are likable to emotions like fear or excitement. They use chart patterns to analyze market movements and to understand the trends. 

Using Technical Analysis

The technical analysis predicts price movements of any tradable instrument such as bonds, stocks, futures, and currency pairs, as long as these are dependent on the forces of supply and demand. Some take technical analysis only as the study of the effects of supply and demand. Technical analysis also applies to trade volume and open interest figures.

There are hundreds of patterns and signals developed by researchers to support technical analysis trading. They have also developed many types of trading systems that can help them predict price movement trades. Some indicators focus on market trends, while other signs focus on the strength or weakness of a trend and its probability of continuing.

Generally, technical analysts focus on the following:

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

Technical Analysis and its Limitations

Another criticism of technical analysis is that it only works in limited cases because it is a self-fulfilling prophecy. An example is when traders who use technical analysis place a stop-loss order below a company’s 200-day moving average. When a lot of traders have done so, and the stock reaches the said price, there will be too much sell orders, pushing the stock down, therefore the anticipated movement of the trend.

As this continues, more traders will sell as they see the price decrease. This reinforces the strength of the trend. However, this kind of short-term selling movement will have little bearing on the asset’s price in the coming days, no matter how self-fulfilling it was for a short time. So to summarize, if enough people get pressured by the trend, it will lead to the anticipated movement. However, in the long run, if technical traders filled the market, it will not drive the price of every asset.