Technical Analysis is the forecasting of future financial price movements based on an examination of past price movements and volume. It can help investors anticipate what is “likely” to happen to prices over time. Despite all the fancy and exotic tools it employs, technical analysis really just studies supply and demand in a market in an attempt to determine what direction, or trend, will continue in the future. In other words, technical analysis attempts to understand the emotions in the market by studying the market itself, as opposed to its components.
Technicians employ many methods, tools and techniques as well, one of which is the use of charts. Using charts, technical analysts seek to identify price patterns and market trends in financial markets and attempt to exploit those patterns. Technical analysts also widely use market indicators of many sorts, some of which are mathematical transformations of price, often including up and down volume, advance/decline data and other inputs. These indicators are used to help assess whether an asset is trending, and if it is, the probability of its direction and of continuation. Technicians also look for relationships between price/volume indices and market indicators.
Assumptions for technical analysis:
- Price discounts everything.
- Price movements are not totally random
- What is more important than why
Price discounts everything: This theorem is similar to the strong and semi-strong forms of market efficiency. Technical analysts believe that the current price fully reflects all information. Because all information is already reflected in the price, it represents the fair value, and should form the basis for analysis. Technical analysis utilizes the information captured by the price to interpret what the market is saying with the purpose of forming a view on the future.
Price movements are not totally random: Technical analysts believe that prices trend directionally, i.e., up, down, or sideways (flat) or some combination. However, most technicians also acknowledge that there are periods when prices do not trend. If prices were always random, it would be extremely difficult to make money using technical analysis.
“What” is more important than “why”: Technicians, as technical analysts are called, are only concerned with two things:
- What is the current price?
- What is the history of the price movement?
Technical analysts believe that investors collectively repeat the behavior of the investors that preceded them. To a technician, the emotions in the market may be irrational, but they exist. Because investor behavior repeats itself so often, technicians believe that recognizable (and predictable) price patterns will develop on a chart. The price is the end result of the battle between the forces of supply and demand for the company's stock. The objective of analysis is to forecast the direction of the future price. By focusing on price and only price, technical analysis represents a direct approach.
Technical analysts consider the market to be 80% psychological and 20% logical. Even though there are some universal principles and rules that can be applied, it must be remembered that technical analysis is more an art form than a science. As an art form, it is subject to interpretation. However, it is also flexible in its approach and each investor should use only that which suits his or her style. Developing a style takes time, effort and dedication, but the rewards can be significant.