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Technical analysis is the forecasting of future financial price movements based on an examination of past price movements. Like weather forecasting, technical analysis does not result in absolute predictions about the future. Instead, technical analysis can help investors anticipate what is “likely” to happen to prices over time.
Technical analysis is applicable to stocks, indices, commodities, futures or any tradable instrument where the price is influenced by the forces of supply and demand. Price data (or as John Murphy calls it, “market action”) refers to any combination of the open, high, low, close, volume, or open interest for a given security over a specific timeframe.
How to Master Technical Analysis Easily
The timeframe can be based on intraday (1-minute, 5-minutes, 10-minutes, 15-minutes, 30-minutes or hourly), daily, weekly or monthly price data and last a few hours or many years.
Technical analysis uses a wide variety of charts that show price over time.
Key Assumptions of Technical Analysis
Technical analysis is applicable to securities where the price is only influenced by the forces of supply and demand. Technical analysis does not work well when other forces can influence the price of the security. In order to be successful, technical analysis makes three key assumptions about the securities that are being analyzed:
- High Liquidity – Liquidity is essentially volume. Heavily-traded stocks allow investors to trade quickly and easily, without dramatically changing the price of the stock. Thinly-traded stocks are more difficult to trade, because there aren’t many buyers or sellers at any given time, so buyers and sellers may have to change their desired price considerably in order to make a trade.
In addition, low liquidity stocks are often very low priced (sometimes less than a penny per share), which means that their prices can be more easily manipulated by individual investors. These outside forces acting on thinly-traded stocks make them unsuitable for technical analysis.
- No Artificial Price Changes – Splits, dividends, and distributions are the most common “culprits” for artificial price changes. Though there is no difference in the value of the investment, artificial price changes can dramatically affect the price chart and make technical analysis difficult to apply. This kind of price influence from outside sources can be easily addressed by adjusting the historical data prior to the price change.
It is important to determine whether or not a security meets these three requirements before applying technical analysis. That’s not to say that analysis of any stock whose price is influenced by one of these outside forces is useless, but it will affect the accuracy of that analysis.
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The Basis of Technical Analysis
At the turn of the century, the Dow Theory laid the foundations for what was later to become modern technical analysis. Dow Theory was not presented as one complete amalgamation, but rather pieced together from the writings of Charles Dow over several years. Of the many theorems put forth by Dow, three stand out:
- 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.
After all, the market price reflects the sum knowledge of all participants, including traders, investors, portfolio managers, buy-side analysts, sell-side analysts, market strategist, technical analysts, fundamental analysts and many others.
It would be folly to disagree with the price set by such an impressive array of people with impeccable credentials. 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.
Prices Movements are Not Totally Random
Most technicians agree that prices trend. 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. In his book, Schwager on Futures: Technical Analysis, Jack Schwager states:
“One way of viewing the situation is that markets may witness extended periods of random fluctuation, interspersed with shorter periods of nonrandom behavior… The goal of the chart analyst is to identify those periods (i.e. major trends).”
A technician believes that it is possible to identify a trend, invest or trade based on the trend and make money as the trend unfolds. Because technical analysis can be applied to many different timeframes, it is possible to spot both short-term and long-term trends.
The IBM chart illustrates Schwager’s view on the nature of the trend. The broad trend is up, but it is also intersperse with trading ranges. In between the trading ranges are smaller uptrends within the larger uptrend. The uptrend is renewe when the stock breaks above the trading range. A downtrend begins when the stock breaks below the low of the previous trading range.
“What” is More Important than “Why”
In his book, The Psychology of Technical Analysis, Tony Plummer paraphrases Oscar Wilde by stating, “A technical analyst knows the price of everything, but the value of nothing”. Technicians, as technical analysts are calle, are only concerne with two things:
- What is the current price?
- What is the history of the price movement?
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. Fundamentalists are concerne with why the price is what it is.
For technicians, the why portion of the equation is too broad and many times the fundamental reasons given are highly suspect. Technicians believe it is best to concentrate on what and never mind why. Why did the price go up? There were simply more buyers (demand) than sellers (supply). After all, the value of any asset is only what someone is willing to pay for it. Who needs to know why?
General Steps to Technical Evaluation
Many technicians employ a top-down approach that begins with broad-base market analysis, then narrows down to specific sectors/industries and ultimately to an analysis of individual stocks.
The beauty of technical analysis lies in its versatility. Because the principles of technical analysis are universally applicable, each of these levels of analysis can be performe using the same theoretical background. You don’t need an economics degree to analyze a market index chart.
You don’t need to be a CPA to analyze a stock chart. Charts are charts. It does not matter if the timeframe is 2 days or 2 years. It does not matter whether you are looking at a stock, market index or commodity. The technical principles of support, resistance, trend, trading range and other aspects can be applie to any chart. As simple as this may sound, technical analysis is far from easy. Success requires serious study, dedication, and an open mind.
Technical analysis can be as complex or as simple as you want it. The example below illustrates some basic principles of chart analysis. Since we are intereste in buying stocks, the focus will be on spotting bullish situations in this chart.
Overall Trend: The first step is to identify the overall trend. This can be accomplishe with trend lines, moving averages or peak/trough analysis. For example, the trend is up as long as price remains above its upward sloping trend line or a certain moving average. Similarly, the trend is up as long as higher troughs form on each pullback and higher highs form on each advance.
Support: Areas of congestion and previous lows below the current price mark the support levels. A break below support would be considere bearish and detrimental to the overall trend.
Resistance: Areas of congestion and previous highs above the current price mark the resistance levels. A break above resistance would be considere bullish and positive for the overall trend.