Technical analysis can be defined as a method that attempts to forecast future price trends by the means of analyzing market action. It was established as early as 18th century. However, most of its methods as we know them today were created in the first decades of 20th century.
The core idea of technical analysis is that history tends to repeat itself. That is why we can find certain situations in the market that occur regularly. These situations can be discovered by chart analysis and technical indicators, which we can use for our advantage – and that is precisely what technical analysis is trying to do.
There are several approaches to technical analysis – such as the Dow theory, Elliot wave theory, Fibonacci's analysis, cyclical analysis and so on. However, the most commonly used methods can be divided into two major branches – namely chart analysis (also called charting) and statistical approach. With chart analysis, the analyst is trying to find patterns that price creates in the chart and that occur repeatedly. For example, head and shoulders or double bottoms are considered typical chart patterns. As soon as the analyst identifies such a pattern, he can make a trade based on the direction the price should follow based on the type of the pattern.
Another branch of technical analysis is constituted by the statistical techniques, which comprise mostly the study and use of various technical indicators. These indicators are computed from historical market data and are mostly used for forecasting trend reversals or changes in strength of the trend. Many of the indicators yield precise buy and sell signals. There are several kinds of indicators – from the very simple ones like moving averages to the very complicated such as Swing index, for which the mathematical formula is several lines long. Yet, the major drawback of using technical indicators is that they provide too many trading signals that are often contradicting each other. It is so because different indicators work best in different kind of market (or phase of the trend). In the following articles, explaining various technical indicators will be our primary concern.
The key premises of technical analysis
1. Prices move in trends
The first and also the key premise of technical analysis is that asset prices tend to move in trends. Three kinds of trends exist- the upward trend (bullish), the downward trend (bearish) and no trend (sideway move). In case of a sideway move, prices oscillate in a narrow range for some time, whereas their future direction is hard to determine. According to technical analysis, a trend is in effect until it reverses. That's why most traders focus on trading the market at the time of trend reversals, as it is at that time when the biggest price moves occur, which means high potential for profitable trades.
However, there is not only one trend in a stock chart. On the contrary, there are several trends in one chart. For example, in a monthly chart we can find a long-term trend, which actually consists of many smaller trends. In a daily chart we can find a daily trend, in an hour chart an hour trend and in a minute chart a minute trend. Most of technical analysts recommend trading in the direction of the trend. They usually start by determining direction of the long-term trend and then gradually move to lower timeframes, whereas the key trend to watch should be the one corresponding to the time horizon during which we want to have the position open.
2. Price discounts everything
Technical analysis is a kind of market analysis that compared to the fundamental analysis does not require constant monitoring of vast amount of information from various sources. On the contrary, it is based on the belief that all relevant information are already reflected in the market price and any new information will impact the price as soon as they are released. That's why for the purpose of conducting technical analysis, all you need to watch is market price and volume traded. In case of futures, you need to watch for another figure – the open interest indicator (the amount of currently outstanding contracts in the market). Hence, it is completely sufficient for a purely technical trader to have only a data feed consisting of market price and volume traded in real time, which is usually already included in a broker's basic fee. We can say that while a fundamental analyst attempts to determine or at least estimate a company's intrinsic value, a technical analyst does not concern himself with this value at all. His only concern is whether the price of its shares will go up or down in the future. But, as opposed to a fundamental analyst he does not care why this happens. Thus, a technical trader does not have to subscribe to expensive information services such as Reuters or Bloomberg, and hence he can save a lot of money.
Moreover, technical analysis can be applied practically to every market – to equities, bonds, commodity futures, currencies, etc. Therefore, a technical analyst has a substantial advantage over his fundamentally oriented peer, because he can always choose to trade the market in which there is currently most action, as he is not bound to a particular market.
3. History repeats itself
Because all the concepts of technical analysis are based on studying historical data, validity of this premise is crucial. Several studies have shown that particular events occur repeatedly in the market. These events are reflected in market price, which is again the primary source of information for particular indicators and chart analysis. Many of them are based on patterns in human psychology that do not change. For example, one such situation is regularly visible when resistance (a psychological bareer limiting the price rise on the upside) is broken. If the price breaks above the resistance level, traders who have opened long positions cheer, but at the same time they regret that they didn't buy more. Traders with short positions realize they are on the wrong side of the trend and hope that the price will drop back to the level of former resistance, so they could exit their positions without incurring losses. Traders that have not yet committed any money in the market are waiting for the price to drop towards the level of former resistance as well, in order to be able to initiate long positions and capitalize on the upward trend, while buying cheaply. Because all these groups intend to buy near the level where the resistance was, this level becomes a support for price – prices will not fall under this level because of high demand. Technical analysis includes many such concepts.
In spite of the fact that technical analysis has been used for decades by almost all exchange traders (including major banks and mutual funds), many people (mostly academics) still reject it and criticize it as subjective, random and often also completely redundant. For example, according to the efficient market theory, it should not provide any benefit even if the efficiency of the market was low, because all publicly available information should be already reflected in market price. Many professors still call it a “pseudoscience”.
The truth is that technical analysis is indeed highly subjective. On one hand, it is the case because while studying charts and looking for patterns everyone can see a very different thing. Also, there is a vast array of technical indicators and every analyst uses only a few of her favorite ones and can even adjust or calibrate them differently. Therefore, it is quite common for two technical analysts to reach completely different conclusions for a single market. Nonetheless, similar situations also occur while using fundamental or psychological analysis, so technical analysis is not an exception.
Another often mentioned argument against technical analysis is that it is a self-fulfilling prophecy. It is mostly because of trend-following systems used by traders, as well as the automated trading systems (computer programs generating trading orders often based on technical analysis). It is estimated that automated trading systems generate more than 50% of all orders in stock trading. The problem is that the vast majority of these systems is based on exploiting the existing trend, and so they buy when prices are rising and sell when prices are falling. But, when they're buying stocks in an uptrend, they raise the price even further and vice versa. Thus, such systems contribute to increased volatility in the market and reinforce the current trend. Fortunately, these systems just like the analysts use different indicators and that's why they do not trade identically. Besides, many of these systems are programmed to detect the state when prices are rising or falling too fast and exploit it (for example buying after a steep fall in price). Many traders use similar tactics, so this criticism is not justified, either.
As technical analysis (and especially chart analysis) is highly subjective, its success is highly dependent on how experienced its user is. The more experience an analyst has, the better he can determine the kind of pattern or a possible trend reversal. That's why many traders combine technical analysis with fundamental analysis. In that case, technical analysis is most suitable for planning the entry and exit points for the positions, which especially in futures trading make a difference between profit and loss.