What is Technical Analysis?

"Technical Analysis is the study of market action, primarily through the use of charts, for the purpose of forecasting future price trends." - John Murphy in "Technical Analysis of the Financial Markets"

This means that by looking at what prices did in the past you will be able to predict the future, at least to a certain extend. When talking about market action as Murphy does in his book "Technical Analysis of the Financial Markets", three parameters are being taken into consideration: price, volume and open interest. If we look at the philosophical premises of Technical Analysis, we learn that according to John Murphy, the combination of these three parameters, quicker referred to as market action, discounts everything.

Market action discounts everything

What does this mean? No matter what the circumstances say, what the news will try to make you believe or what the latest expert is advising, the activity of the market is the primary thing to look at. In case of doubt, the movement of the price and the behavior of other traders in the market represented through volume and open interest will always show you the reality, because all fundamental, political and economic information available to the market is reflected in the PRICE.

If prices are rising, the demand is more than the supply, which means that the fundamentals are good. If prices fall, supply is more than demand, meaning the fundamentals must be bad. If you know how to read your charts properly, you will soon be able to identify the bearish and bullish psychology of the marketplace that is shown in the charts. While fundamentalists try to explain why prices rise or fall, Technical Analysts are not concerned with the reasons why prices behave a certain way.

Prices move in trends

Charles Dow who developed the Dow Theory based on his observation of trends more than a century ago found out that prices move in trends. This means that prices never move in straight lines but in so called "zig zags". The Technical Analysis takes advantage of this premise and identifies trends in their early stages of their development in order to trade in the direction of those trends. According to the Law of Momentum published by Isaac Newton, an object that is in motion can only be stopped through a major force. The same is true for trends - once in motion it is more likely that they will continue than to reverse.

History repeats itself

Basic human nature does not change and the market that reflects the sum of all participants' actions behaves in identifiable patterns. By identifying specific chart patterns that have been correct throughout history, a Technical Analyst will be able to predict the movement the market will do after forming this pattern, most probably. It can be compared with weather forecasting although this might not be the best comparison since weather forecasts are hardly precise. In order to be able to understand the future, you have to study the past.

Technical Analysts don't rely on fundamentals, especially when exiting or entering a specific trade. This way of analyzing the market will allow you to precisely identify when to enter and when to exit a trade.

How does Technical Analysis look compared to Fundamental Analysis?

The goal of fundamental analysts is to identify the intrinsic value of a specific market. After having identified it, they will make the decision whether it is overvalued, which means that they will sell, or on the opposite, undervalued, which means that they will buy. The theory of the intrinsic value says that a specific financial instrument has a certain value. It is either overvalued, which means that it is basically traded above its actual value and should be sold immediately, because it will drop in value very soon due to its tendency to fluctuate around and return to its intrinsic value. The same is true for an undervalued instrument. In this case, you want to buy as soon as possible in order to profit from its return to the price level of its actual value, since it is moving below this point at the moment.

Both philosophies aim at forecasting the direction of prices. The "Fundamentalists" study the cause of a market movement while "Technicians" study only the EFFECT. Fundamental Analysts have the urge to know why prices move in a certain direction whereas Technical Analysts consider the effect as the most important and sole thing they should know. They are hardlyconcerned with the reasons and causes of a price movement - they don't need to know why.

Where do these two approaches disagree the most? They disagree the most at critical turning points. Fundamentalists cannot explain the market movement at the beginning of an important market move. Prices tend to lead the known fundamentals and major bull and bear markets throughout history begun with little to almost no change in the fundamentals.

What most people don't realize is that the technical approach does include the fundamental approach. Since the fundamentals are reflected in the price the sole studying of fundamentals is not necessary. If you know how to read charts properly, it is a shortcut of the fundamental analysis. On the opposite, fundamental analysis does not include a study of price action. Even if the principles of the fundamental analysis have been applied, the timing for finding entry and exit points has to rely on Technical principles.

Advantages of Technical Analysis

Applying the principles of Technical Analysis gives you a lot of flexibility and adaptability. If you work with fundamentals, it is hardly possible to follow the news for more than a handful of instruments. Since the principles of the TA never change and are the same for every instrument, you can easily change from on to another and adapt your trading within a short amount of time. Technical Analysis can be applied to different time frames as well and can play a role in Economic Forecasting.

In contrast to Fundamentalists who tend to specialize in one group, a chartist can easily follow as many markets as desired. He can rotate his attention and his capital to take advantage of the rotational nature of the markets. While on of his preferred instruments is experiencing a trendless period in which it is not advisable to trade, he can easily switch to another instrument and take advantage of the recent trend.

Technical Analysis applies to all markets (the most common are: bonds, equities, futures, interest rates, foreign exchange and derivatives) and to all time dimensions. The opinion that TA should only be used in short-term time frames is not true. Typical time frames are:

  • Very short-term
  • Short term: hourly charts
  • Medium term: daily charts
  • Long term: weekly charts
  • Very long term: monthly charts

Criticism of Technical Analysis

Self-Fulfilling prophecy

Critics claim that the use of most patterns has been widely publicized in the last several years. Many traders are quite familiar with these patterns and often act on them in concert. This creates a "Self-Fulfilling Prophecy", since waves of buying and selling are created in response to "bullish" or "bearish" patterns. The truth is that only 30% of all traders use Technical Analysis. This is hardly enough for a "Self-Fulfilling Prophecy". Furthermore, chartist will enter the trades AFTER a formation has been formed, not before or during the creation of a pattern.

Can the Past be used to predict the future?

In the respected field of statistics, the characteristics of past events are collected, studied and analyzed. According to the result, future predictions are being concluded. This counts for economic, technical and weather forecasting. The only possibility to forecast the future is to project past events into it. The usage of price data to predict future price movement is based on solid statistical concepts, such as descriptive and inductive statistics).

Efficient Market Hypothesis

This theory says that prices fluctuate randomly around their intrinsic value. On top of that it claims that all news, new data and relevant information comes to everyone at the same time - so no one can take advantage of it. The basis of Technical Analysis and its principles is that relevant market information is obvious on the charts long before it becomes publically known.

Random Walk Theory

This theory claims that prices change serially independent from each other and that the history of price is not a reliable indicator for future prediction. According to this theory, price movement is completely random and absolutely unpredictable, since it is based on Efficient Market Hypothesis. There is a certain amount of randomness from time to time, which is called noise. Someone who claims that price movements are completely random has not taken the time to study the rules of market behavior properly. Yet. Apart from
that empirical observations show that prices do move in trends.

Conclusion

While Fundamental Analysis may have its relevancy, especially for other purposes, I am convinced that Technical Analysis is the far more precise, reliable and efficient method to base your trading on. Among all reasons mentioned above, the flexibility, adaptability and precisions are the deciding factors for me personally.


Written by Nico Strobl, May 22nd 2014 Nico Strobl