Technical analysis

Charting or technical analysis is the study of price action in markets through the use of charts and quantitative techniques to attempt to forecast price trends.

The techniques can be applied to any market with a comprehensive price history. Technical analysis does not try to analyze the financial data of a company, such as cashflow, dividends, and projection of future dividends; because of this lack of fundamental analysis, technical analysis is sometimes derided by critics as having no predictive qualities. Technical analysts or technicians often counter with an industry favorite analogy: A fundamental analyst gives an hour long description of a company's financial health to a potential investor. Pleased with his presentation, the analyst asks, "Are there any questions?" The investor replies, "So is the stock price going up or down?" Technical analysis is less concerned with why a price is moving (poor earnings, difficult business environment, poor management, etc. I.e., its fundamentals) than it is on the fact that the price is consistently moving in a particular direction. To a technician, profits can be made in any market by positioning yourself in the direction of the price trend. If the price trend is up, then look for opportunities to buy, if the price trend is down, then look for opportunities to sell.

Some academics dismiss technical analysis for being too simplistic, but technical analysis definitely has supporters in academia. For example, in 2000, the Federal Reserve Bank of New York produced a study that concluded that technical analysis had predictive power in exchange rates markets. See: FedReport (http://www.ny.frb.org/research/epr/00v06n2/0007osle.html)

In 2005, the US Securities and Exchange Commission, New York Stock Exchange, and National Association of Security Dealers (NASD) amended their definition of "research analyst" to include both fundamental analysts and technical analysts. Formerly, a research analyst as defined by the aforementioned had to be a fundamental analyst and needed to pass a proficiency exam (Series 81). The rule now specifies that a person with demonstratable proficiency in technical analysis (by studying for the CMT--see below) is also a research analyst. Thus, US regulatory agencies now view technicians and fundamental analysts on equal footing.

Contents

1 Three Beliefs of Technical Analysis

2 Other

3 Criticism of Technical Analysis

4 Proponents of Technical Analysis

5 Techniques of technical analysts

11.1 Finding related topics

12 External links

12.1 Technical analysis software
12.2 Useful URLs
12.3 Indicators

12.3.1 Indices

12.4 Sectors

12.4.1 Gold

Three Beliefs of Technical Analysis

Price action in the market discounts everything

Technical analysis holds that because every possible bit of information is included in a security's price, it is not necessary to explicitly analyze the fundamental, economic, political, etc. factors that might influence that price. Because all available information is already included in the current price, only a study of the price movement is required.

Prices move in trends

While it is not explicitly proven that prices must trend, technical analysis relies on empirical evidence and simple common sense to assert that prices do trend. For example, if homeowners believed that interest rate increases will erode the value of their homes, they will be inclined to sell. If there were three similar homes in a neighborhood up for sale, the first house could be sold for $100,000, the second could be sold for $97,500 and perhaps the third could sell for $95,000. Rather than immediately drop down to some formulaic price based on interest rates and other inputs, prices will move consistently over time in one direction. (In a large market like global equities with many participants, prices will move in a zig-zag fashion in one direction.) Prices will continue to decline until there is a balance between buyers and sellers. This gradual (but sometimes quick) directional movement in prices (the trend) is what technical analysis attempts to identify and exploit. If a technical analyst could enter this market, he or she would likely sell short a house because the price trend is downward. A person who does not believe that prices move in trends will find little use of technical analysis. The idea that prices trend is probably the most important concept in technical analysis. An example of a security that is trending is AOL from November 2001 through August 2002 seen below. A technician or trend follower recognizing this trend would look for opportunities to sell this security. AOL consistently moves downward in price. Each time the stock attempted to rise, sellers would enter the market and sell the stock. Hence the "zig-zag" movement in the price. The series of "lower higs" and "lower lows" is a tell tale sign of a stock in a down trend. In other words, each time the stock edged lower, it went lower than its previous relative low price. Each time the stock moved higher, it couldnt reach the level of its previous relative high price. Note that it is not until August that the sequence of lower lows and lower highs is broken. In August the stock makes a low price that doesnt pierce the relative low set earlier in the month. Later in the same month, the stock makes a relative high equal to the most recent relative high. To a technician, those are strong indications that the down trend is at least pausing and possibly ending. A technician would likely stop actively selling the stock at this point.

An interesting contrast can be demonstrated between a fundamental analyst's and a technical analyst's approach to this stock. In January 2002, a popular fundamental analyst stated that based on her analysis of the company's finances, AOL should trade at about $39. At the time, AOL was trading at approximately $25 so she recommended buying the stock. On the other hand, a technician would likely note that at the time of the analyst's prediction, the stock was still trending downward. The technician would continue to look for opportunities to sell until signs of the trend ending appeared in the price action. The fundamental analyst might be correct in that AOL should trade around $39 (she was not in this case) but all that matters to the technician is the price action in the market.

Missing image
AOLTIMEWARNERCHART2001.png
AOL TimeWarner

History tends to repeat itself

Technical analysis believes that investors en masse display much of the same behavior as the investors that preceded them. "Everyone wants in on the next Microsoft," "If this stock ever gets to $50 again, I will buy it," "This company's technology will revolutionize its industry, therefore this stock will skyrocket,"--these are all examples of investors' attitudes repeating. To a technical analyst, the human characteristics of the market might be irrational but nonetheless they exist. Because investors' attitudes often repeat, investors' actions in the marketplace often repeat as well. I.e., patterns of price movement will develop on a chart that a technical analyst believes have predictive qualities.

It is important to understand that the realm of technical analysis is not limited to charting. Technical analysis is always primarily concerned with price trends. Anything that can influence the price trend is of interest to a technician. As an example, many technicians monitor surveys of investor enthusiasm. These surveys attempt to gauge the general attitude of the investment community to determine whether investors are bearish or bullish. Technicans use these surveys to help determine whether a trend will reverse or whether a new trend will develop. A technican would be alerted that a trend might change when these surveys report extreme investor reactions. When surveys are overly bullish, for example, a technician will look for evidence that an up trend will reverse. The logic being that if most investors are bullish, then they would have already bought the market (anticipating that the market will move higher). But because most investors are bulllish and have invested, it is safe to assume that there are few buyers remaining in the market. With most investors long, there are more potential sellers in the market than buyers despite the fact that the overall attitude of investors is bullish. This implies that the market is set to trend down and is an example of a technical analysis concept called contrarian trading.

Other

The industry is represented in the U.S. by the Market Technicians Association (http:www.mta.org) The organization awards the Chartered Market Technician certification to candidates who have demonstrated mastery of technical analysis concepts via a battery of exams or through a research paper on technical analysis.

While technical analysis is widely used (if only as one input among many) by both professional and amateur traders as a means of predicting future market moves, it is generally not used by economists in any academic sense.

A common misconception about technical analysis is that it explicitly rejects the efficiency of the market as understood in the efficient market hypothesis (EMH). That is, using technical analysis on a particular market implicitly assumes that that market is not efficient, as defined by EMH. The efficient markets theories basically argue that existing prices reflect all available information, and that future price movements will follow a path that will approximate to a random walk (Brownian motion) as they adjust to new information as it emerges. The theories further assume that all participants in the stock market have equal and instantaneous access to all information that might affect securities. Technical analysis shares the notion that prices incorporate all available information. That is why only price needs to be studied, according to a chartist. Technical analysis is more at odds with random walk theories. Chartists maintain that prices cannot move in a random, yet definable, fashion. Otherwise, price trends would rarely develop.

Criticism of Technical Analysis

Technical Analysis Principles are Self-Fulfilling

Some claim that because the price patterns of technical analysis are widely disseminated throughout the investment community and that traders are so familiar with them, technicians act on them together unknowingly. These bursts of buying and selling appear to give credence to the predictive claims of the patterns when no such predictive quality exists.

Chartists counter that if it were the case that they were acting in concert with each other, the same signals that told them all to buy would tell them all to sell. I.e., none of them would make any money trading. Since this is not the case, they claim, technical analysis principles are not self-fulfilling.

Chartists also point out that pattern recognition is somewhat subjective so it would be impossible for their entire community to act as one.

Prior Price Action Has No Bearing on Future Price Action

Critics say that technical analysis's reliance on past price data is not grounded in any scientific discipline and therefore has no bearing on future price movements.

Proponents of technical analysis claim that any descriptive statistical analysis relies upon prior price data to generate predictions or likely outcomes. Some go so far as to say that technical analysis is merely a type of time series analysis.

Pure fundamental analysts are typically the staunchest critics of technical analysis as they believe that the only correct way to determine a security's price is through the analysis of the security's finances--something which technical analysis says is not necessary to examine. Understandably there is some industry pride at stake on both sides of the issue so the pure fundamental camp will probably continue to trade barbs with the pure technical camp.

Proponents of Technical Analysis

To many traders, trading in the direction of the trend is the most effective means to be profitable in financial or commodities markets. John Henry, Larry Hite, Ed Seykota, Richard Dennis, Bruce Kovner, and Michael Marcus (some of the so-called Market Wizards in the popular book of the same name by J. Schwager) have each amassed massive fortunes through the use of technical analysis and its concepts. Many non-arbitrage computer trading systems are trend following systems as are many hedge funds. They all rely heavily on technical analysis principles.

Techniques of technical analysts

The traditional chartists developed familiarity with chart patterns that seemed to recur repeatedly and gave some of them names, e.g. "head and shoulders" or "flag" or "triangle". They believed that they could infer probabilities of price action from studying the patterns.

More recent technical analysts use a wide variety of techniques. There are dozens of technical indicators and studies. Some of which are described below. An exhaustive list can be found at the [MTA (http://www.mta.org)] website.

The most sophisticated technical analysis software allows the user to design indicators and to optimise them by testing their profitability (assuming trading rules and transactions costs) using historic data; trading stratagems can be designed that utilise one or more such indicators.

Charting terms

Some of the techniques used and patterns found include:

Arms Index (TRIN) -
Ascending bottom -
Bollinger Bands - a range of price volatility based on the standand deviation on an average of the closing price.
Box-breakout - when prices pass through, and stay beyond horizontal support and resistance areas resembling a box.
Breakout - when prices pass through, and stay through an area of support or resistance.
Broadening foundation -
Commodity Channel Indicator -
Gann lines and Gann angles -
Head and shoulders - top, higher top, lower top.
Inverse head and shoulders - bottom, lower bottom, higher bottom.
Lane’s Stochastics - indicates entry signals based on reactions of professional traders on the close.
MACD - Moving Average Convergence/Divergence
Momentum - Comparison of current price to previous price.
Money Flow - the proportion of total stock trades that were traded on days the price went up.
Moving average - the average of price, volume or open interest for an arbitrary number of periods.
On Balance Volume - an indicator showing momentum of buying and selling of the stock.
Parabolic SAR - Wilder's trailing stop based on prices tending to stay within a parabolic curve during a strong trend.
Point and figure charts - charts based on price without time.
Relative Strength Index - Wilders (RSI) measures the relative gains over relative losses over time.
Resistance - an area that brings on increased selling.
Stochastic Oscillator - an oscillator based on the notion that as prices trend upward (or downward), daily closing prices tend to approach the day's high (or low) price.
Stop loss - executes a trade based on price action.
Support - an area that brings on increased buying.
Trend line - a sloping line of support or resistance.
Trend line penetration - a trend line penetration occurs when prices break through a sloping line of support or resistance leading to a breakout.
Triangle - converging and diverging areas of support and resistance areas resembling a Triangle.
Triple top - top, top, top

Interpretation

Chart patterns reflect human actions as they effect supply and demand. Oscillators smooth these patterns, in an attempt to filter out the noise. Trendlines, support, resistance, box breakouts etc. can be drawn on oscillators as well as price.

There are 4 common methods to interpret indicators:

1. Crossovers – uses the relationships between short and long term moving averages.
2. Divergence/Convergence – patterns formed by the relationship between indicators and closing prices.
3. Overbought/oversold - When the indicator raises rapidly in a congestion area it may be a signal the security will soon return to normal levels.
4. Pop – When the indicator rises rapidly and continues to trend, it may be a signal the securities will be seeking new extremes.

When you run the Oscillator over the history of the security you will be trading, you can see how it behaves before the pattern that you like to trade developes.

Books

Technical Analysis of Futures Markets, John J. Murphy, New York Institute of Finance, 1986, ISBN 0-13-898008-X
The Profit Magic of Stock Transaction Timing, J.M. Hurst, Prentice-Hall, 1972, ISBN 0137260180
New Concepts in Technical Trading Systems, J. Welles Wilder, Trend Research, 1978, ISBN 0894590278
Reminiscences of a Stock Operator, Edwin Lefèvre, John Wiley & Sons Inc, 1994, ISBN 0471059706

Glossary

Commodity Futures Trading Commission Glossary (http://www.cftc.gov/opa/glossary/opaglossary_a.htm/)

National Futures Association Glossary (http://www.nfa.futures.org/basicnet/Glossary.aspx/)

Articles

Why the stochastic is fantastic [1] (http://moneycentral.msn.com/articles/invest/strat/2820.asp?Printer)

Chart Watchers Weekly (http://www.stockcharts.com/commentary/archives/cww20010505h.html) - 5 May 2001 - Bullish Percent Index

External links