Introduction to Technical Analysis
The two most common forms of market analysis are fundamental analysis and technical analysis. Fundamental analysis involves analysing an asset using various parameters to measure the asset’s intrinsic value. These parameters include macroeconomic factors i.e. factors related to the overall economy and business conditions, as well as microeconomic factors i.e. factors that impact the movement of a specific asset.
On the other end of the spectrum is technical analysis, which involves analysing market action by studying past movement of an asset and then using this information to predict the future price trajectory of the asset.
Assumptions of Technical Analysis
Technical analysis is based on three important assumptions mentioned below:
- Current price discounts every information The assumption that current price discounts everything is possibly the most important premise of Technical Analysis. When applying Technical Analysis, the analyst must assume that the current price of an asset reflects every available piece of information that could possibly impact the demand and supply of the asset. The only exception to this is acts of god such as earthquakes, tsunamis etc. as such natural events cannot be anticipated beforehand. Nonetheless, the impact of such events, once they occur, is quickly discounted by the market and reflected in the price of an asset.
- Price changes are not random This is possibly the second most important assumption of Technical Analysis. When analysing an asset, the analyst must assume that price of the asset trends and that changes in price are not random. The basic premise behind this assumption is that unless an analyst accepts that price trends, there is no point in analysing an asset from a technical standpoint. In fact, the objective of Technical Analysis is to identify the prevailing trend of the asset and then to ride on that trend until evidence emerges that the trend is possibly reversing or has already reversed. There are three types of trend, each of which will be discussed later.
- History tends to repeat itself The next major premise of Technical Analysis is that history tends to repeat itself. We will be discussing a lot of price patterns later as we progress through the course. These price patterns have worked very well in the past and as such it must be assumed that they will work well in the future also. Recognizing a specific price pattern that is unfolding and knowing that such patterns have worked well in the past enables an analyst to use such information to predict the future movement of an asset. After all, while time keeps changing, the basic human psychology relating to greed and fear remains the same, thereby causing patterns to keep repeating.
Technical analysis is the study of financial market action. The technician looks at price changes that occur on a day-to-day or week-to-week basis or over any other constant time period displayed in graphic form, called charts. Hence the name chart analysis. A chartist analyzes price charts only, while the technical analyst studies technical indicators derived from price changes in addition to the price charts. Technical analysts examine the price action of the financial markets instead of the fundamental factors that (seem to) effect market prices. Technicians believe that even if all relevant information of a particular market or stock was available, you still could not predict a precise market “response” to that information. There are so many factors interacting at any one time that it is easy for important ones to be ignored in favor of those that are considered as the “flavor of the day.” The technical analyst believes that all the relevant market information is reflected (or discounted) in the price with the exception of shocking news such as natural distasters or acts of God. These factors, however, are discounted very quickly. Watching financial markets, it becomes obvious that there are trends, momentum and patterns that repeat over time, not exactly the same way but similar. Charts are self-similar as they show the same fractal structure (a fractal is a tiny pattern; self-similar means the overall pattern is made up of smaller versions of the same pattern) whether in stocks, commodities, currencies, bonds. A chart is a mirror of the mood of the crowd and not of the fundamental factors. Thus, technical analysis is the analysis of human mass psychology. Therefore, it is also called behavioral finance.
Technical analysis pre-empts fundamental data
Fundamentalists believe there is a cause and effect between fundamental factors and price changes. This means, if the fundamental news is positive the price should rise, and if the news is negative the price should fall. However, long-term analyses of price changes in financial markets around the world show that such a correlation is present only in the short-term horizon and only to a limited extent. It is non-existent on a medium- and long-term basis. In fact, the contrary is true. The stock market itself is the best predictor of the future fundamental trend. Most often, prices start rising in a new bull trend while the economy is still in recession (position B on chart shown above), i.e. while there is no cause for such an uptrend. Vice versa, prices start falling in a new bear trend while the economy is still growing (position A), and not providing fundamental reasons to sell. There is a time-lag of several months by which the fundamental trend follows the stock market trend. Moreover, this is not only true for the stock market and the economy, but also for the price trends of individual equities and company earnings. Stock prices peak ahead of peak earnings while bottoming ahead of peak losses.
The purpose of technical analysis is to identify trend changes that precede the fundamental trend and do not (yet) make sense if compared to the concurrent fundamental trend.
Optimism, pessimism, greed and fear
Why aren´t more people making more money in the financial markets? Because, as we have seen, people are motivated by greed (optimism) when buying and by fear (pessimism) when selling. People are motivated to buy and sell by changes in emotion from optimism to pessimism and vice versa. They formulate fundamental scenarios based on their emotional state (a rationalization of the emotions), which prevents them from realizing that the main drive is emotion.
The chart below shows that if investors buy based on confidence or conviction (optimism) they BUY near or at the TOP. Likewise, if investors act on concern or capitulation (pessimism) they SELL near or at the BOTTOM. Investors remain under the bullish impression of the recent uptrend beyond the forming price top and during a large part of the bear trend. Vice versa, they remain pessimistic under the bearish impression from the past downtrend through the market bottom and during a large part of the next bull trend. They adjust their bullish fundamental scenarios to bearish AFTER having become pessimistic under the pressure of the downtrend or AFTER having become optimistic under the pressure of the uptrend. Once having turned bearish, investors formulate bearish scenarios, looking for more weakness just when it is about time to buy again. The same occurs in an uptrend when mood shifts from pessimism to optimism. Investors formulate bullish scenarios AFTER having turned bullish, which is after a large part of the bull trend is already over. Emotions are the drawback of fundamental analysis. Investors must learn to buy when they are fearful (pessimistic) and sell when they feel euphoric (optimstic). This may sound easy (simple contrary opinion), but without Technical Analysis it is hard to achieve. The main purpose of technical analysis is to help investors identify turning points which they cannot see because of individual and group psychological factors.