Technical Analysis
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Wikipedia-Article "Technical Analysis"
Technical analysis refers to methods that aim to forecast prices of securities in financial markets using charts or quantitative techniques. There are many different methods utilized in technical analysis but they all rely on the same principles, namely that price patterns and price trends exist in the market that can be identified and exploited.
The premises of technical analysis were derived from empirical observations of financial markets. Charles Dow's Dow Theory is considered the foundation for technical analysis, but the realm of technical analysis has been expanded by many further market participants. New theories and tools are produced and existing tools are enhanced. Some common technical analysis tools are listed below.
Technical analysis is less concerned with why a price is moving (poor earnings, difficult business environment, poor management, etc. or other fundamentals) than it is on the fact that the price is moving in a particular direction. To a technical analyst, 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. Similarly, if a particular price pattern was identified in the market, a technical analyst would position himself to take advantage of the expected move that follows that pattern.
Some academic studies of financial markets suggest that technical analysis has little worthwhile predictive power. Still, technical analysis has a loyal and dedicated following especially amongst active traders who defend the practice and believe it can be profitable and there are some scientific studies that support technical analysis.
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'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 the price of a security, 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. Dow Theory provides much of the empirical time-tested support that prices trend to a technical analyst.
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. Moreover, a person who disagrees with Dow Theory will also likely find fault with technical analysis.
An example of a security that is trending is AOL from November 2001 through August 2002. A technical analyst 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 highs" 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 doesn't 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 technical analyst, those are strong indications that the down trend is at least pausing and possibly ending. A technical analyst would likely stop actively selling the stock at this point.
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 technical analyst. As an example, many technical analysts 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. Technical analysts use these surveys to help determine whether a trend will reverse or whether a new trend will develop. A technical analyst would be alerted that a trend might change when these surveys report extreme investor reactions. When surveys are overly bullish, for example, a technical analyst will look for evidence that an uptrend 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.
Criticism of Technical Analysis
The question of documented evidence
Although chartists believe that their techniques provide excess returns over time, not all research agrees with this conclusion. In fact, according to some studies, after trading costs are factored in, the returns generated by many technical analysis strategies may underperform a simple buy and hold strategy.
Proponents of technical analysis, however, maintain that academic research has validated their theories 1. Many large financial institution employ technical analysts to aid them in making investments.
Some scrutinies of the method's technical analysts use have failed to substantiate their claims. This has lead many to reject charting as folly. Critics of technical analysis include some major investors. Warren Buffett once exclaimed, "If past history was all there was to the game, the richest people would be librarians." Most economists do not use technical analysis, but rather rely on analyzing such factors as production, distribution, supply and demand, capital, competition, and resource allocation.
Inconsistencies with Popular Market Theories
The efficient market hypothesis concludes that technical analysis is ineffective. According to this hypothesis, all available relevant information is quickly reflected in a security's price. Thus, it is impossible to "beat the market," and technical analysis cannot work. Advocates of EMH have produced many studies that reject the efficacy of technical analysis.
Some proponents of technical analysis counter that technical analysis does not completely contradict the efficient market hypothesis. Technicians agree with EMH in that that all available information is reflected within a security's price. That is why technicians say a study of the price movement is necessary. Technicians further argue however, that EMH ignores the realities of the market place, namely that many investors base their future expectations on past earnings, track records, etc. Because future stock prices can be strongly influenced by investor expectations, technicians claim it only follows that past prices can influence future prices.
Also, technicians point to the new field of behavioral finance. Behavioral finance essentially says that people are not the rational participants EMH makes them out to be. Market participants can act irrationally. Technicians have long held that irrational human behavior influences stock prices and claim to have ways of predicting probable outcomes based on this behavior.
The random walk hypothesis is also at odds with technical analysis and charting. Essentially, the hypothesis claims that stock price moments are a Brownian Motion with either independent or uncorrelated increments. In this model, future stock prices are not dependent on past stock prices so trends cannot exist and technical analysis has no basis. Again, proponents of this theory have generated a lot of research in support of the hypothesis.
Technical analysts maintain that trends are identifiable in the market and that it is impractical to believe that market prices move in a random fashion. To a technician, over time prices will trend in a direction until supply equals demand. Therefore, there cannot be any pure random price movement. As stated earlier, one of the cornerstones of technical analysis is that prices trend. If one does not believe this concept, one will not agree with technical analysis.
Industry
Globaly, the industry is represented by The International Federation of Technical Analysts (IFTA). IFTA offers certification to professional technical analysts and researchers around the world as part of their Certified Financial Technician designation. In the United States, the industry is represented by two national level organizations: the American Association of Professional Technical Analysts (AAPTA) and the Market Technicians Association (MTA). The MTA awards the Chartered Market Technician certification to candidates who have passed a series of standardized exams. Numerous regional and local societies also exist in the U.S., such as the Technical Securities Analysts Association of San Francisco. In Canada the industry is represented by the Canadian Society of Technical Analysts.
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 Jack D. 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 often rely heavily on technical analysis principles and mathematically complex strategies.
Charting terms
Some of the techniques used and patterns found include:
- Accumulation/distribution index - Chaikin's cumulative volume
- Arms Index (TRIN) -
- Ascending bottom -
- Average true range - averaged daily trading range
- 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 Index -
- Gann lines and Gann angles -
- Head and shoulders - top, higher top, lower top.
- Hikkake Pattern - pattern used for identifying both reversals and continuations, also known as an "inside day false breakout" pattern.
- 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 stocks.
- PAC charts - Two-dimensional method of charting volume by price level.
- 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
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
- Street Smarts, Connors/Raschke, 1995
- Reminiscences of a Stock Operator, Edwin Lefèvre, John Wiley & Sons Inc, 1994, ISBN 0471059706
- Technical Analysis of the Financial Markets, John J. Murphy, New York Institute of Finance,1999,ISBN 0735200661
- Technical Analysis of Stock Trends, 8th Edition (Hardcover), Robert D. Edwards, John Magee, W. H. C. Bassetti (Editor), American Management Association, 2001, ISBN 0814406807
- Introduction to the Magee System of Technical Analysis, 2nd Edition (Hardcover), John Magee, W. H. C. Bassetti (Editor, Coauthor), American Management Association, 2003, ISBN 0814407293
External links
Industry associations
- International Federation of Technical Analysts
- American Association of Professional Technical Analysts
- Market Technicians Association
- Technical Securities Analysts Association of San Francisco