Introduction to technical analysis
This lesson will cover the following
- What is technical analysis
- Three basic assumptions of technical analysis
- Misconceptions of technical analysis
- Advantages and Disadvantages
Technical analysis is a method of evaluating securities by analysing 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 may suggest future activity.
Despite all the exotic tools it includes, technical analysis simply studies supply and demand in a market in an attempt to determine which direction, or trend, is likely to continue. It seeks to understand the emotions in the market by examining the market itself rather than its components. If you understand the benefits and limitations of technical analysis, it can provide you with a new set of tools and skills that will enable you to become a better trader or investor.
As we’ve already mentioned in previous chapters, technical analysis and fundamental analysis are the two main schools of thought in the financial markets. Technical analysis looks at the price movement of a security and uses these data to forecast future price movements. Fundamental analysis, on the other hand, looks at economic data, known as fundamentals.
Technical analysis can be used on any security with historical trading data. This includes Forex, stocks, futures and commodities, fixed-income securities, etc. In this part of the tutorial, we’ll emphasise analysing Forex in our examples, but keep in mind that these concepts can be applied to any type of instrument. In fact, technical analysis is more frequently associated with commodities and Forex.
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Three basic assumptions of technical analysis
The field of technical analysis is based on three assumptions – the market discounts everything, price moves in trends, and 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 analysts assume 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 consider these factors separately. This leaves only 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, 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 analyse 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.
Common misconceptions of technical analysis
Unlike fundamental analysis, which tries to determine the underlying value of a trading instrument, technical analysis looks for the moment when the market begins to spot mispricing. Once the mispricing is identified, the market will tend to correct the situation. This event, however, requires time and occurs gradually, forming a trend on the chart. A technical trader’s aim is to enter the market as the adjustment process is under way and leave once it has come to an end.
A common misconception is that technicians try to predict the future. While some do attempt to do so, they don’t achieve any more success than economists in general. However, those technicians who use their skills to identify trends are the ones who prove successful. Spotting trends is far easier and more profitable than trying to predict the future.
Another common misconception is that it is crucial to identify the beginning and the end of a trend. As with the previous misinterpretation, some technical traders follow this logic but lack consistent success. Conversely, those technicians who enter the trend after it has been confirmed and exit once it has clearly ended prove to be consistently successful. Nevertheless, bear in mind that each trader defines their own unique trading strategy, which represents the art of trading.
Trends and Charts
The beauty of technical analysis lies in its versatility. Because the principles of technical analysis are universally applicable, each of the analysis steps above can be performed using the same theoretical background. You don’t even need an economics degree to analyse a market chart. It does not matter whether it is a share, a currency or a commodity. The technical principles of support, resistance, trend, trading range and other aspects can be applied to any chart. While this may sound easy, technical analysis is by no means an easy approach. Success requires serious study, dedication and an open mind.
One of the most important concepts in technical analysis, alongside charts, is that of a trend. The meaning in finance isn’t all that different from the general definition of the term – a trend is really nothing more than the general direction in which a security or a market is headed.
Advantages and Weaknesses
Advantages
Technical analysis relies only minimally on fundamental data. Economic indicators reflecting job numbers, inflation, retail sales, trade data, etc., are released on a daily basis across the world. For the technical analyst, each piece of news has already been factored into the market’s activity in some form. Therefore, you needn’t wait for the release of monthly or quarterly data, or for some seasonal event to occur; it is easier to observe current price movement and jump into the market.
Another considerable advantage of technical analysis is that it provides you with a quick snapshot of data because it includes all the information you need on one chart – price movement, volume and open interest. By using the right analysis tools, you can determine within minutes whether a trade is worth entering. Another weakness of fundamental analysis, and an area where the technical approach excels, is that technicians can easily estimate their profit targets and risk-management parameters, whereas pure fundamentalists are exposed to a greater degree of risk.
Weaknesses
Of course, technical analysis is not flawless and has soft spots as well. For example, you should be very careful when basing your strategy on lagging indicators because they tell you what has happened in the past and what is happening now, but they can’t reliably predict the future. Therefore, you have to be cautious when attempting to use this type of analysis for predictive purposes (earlier in the article we mentioned that it is far more reasonable to aim at identifying trends).
Another weakness is that technical tools are available to everyone, which means that you will be competing with both novice and expert traders using the same weapons. Since many people use similar strategies, this leads to common and predictable protective stop placements, support and resistance zones, and therefore price fluctuations. To excel, you will need to tune your trading tools and strategy uniquely so that you reduce your predictability and gain an advantage over others.
And last but not least, you will need to learn to interpret the calculations the tools give you better than the rest. Although the numbers themselves quantify deviation, relative strength, etc., it is the interpretation of these figures that matters. There is no wrong way of reading the accumulated data, but there is always a better way.