Technical analysis is the forecasting of future price movements based on past data, by utilizing a multitude of charting techniques. This form of forecasting is applicable to all sectors of financial market i.e., stocks, commodities, forex. The basic precept of technical analysis is based around the concept that price discounts the market, and that they are not a random phenomenon but rather an irrational response of market participants that manifests in discernable pricing patterns over time. The paradigm of Price discounting market movements points to a strong from of market efficiency that is suggestive “that all information in a market, whether public or private, is accounted for in a stock’s price.” Given the fact that price is reflective of the sum knowledge of all market participants i.e., traders, analysts, strategist, thus, it does not make sense to disagree with those well entrenched in the marketplace possibly astute knowledge and reasoning. Thus, a technician believes that it is important to discern trends, and invest in the market as it unfolds. Further, given the fractal nature of market, it is also possible to invest over many different time frames, as the secular trend may be interspersed with miniature trends with both prices surges or declines along with period of consolidation.
This form of market analysis differs from a fundamental analysis approach, as fundamentalists seek to explain the reason of why a price is where it stands rather than technician’s who focus on “what” and not the “why.” So a technician would commence his analysis by first taking a broader view of the industry and then breaking it down to sector level and then the security level aiming to choose the best performing within the group. It is true that technician’s need to be strong chartists but not economists trying to understand the complexities of macro-economics. More so technicians aim to apply a set of rules such as supports, resistance, trends, consolidation, targets, momentum etc. to ascertain the direction of future price movements. They also use charts to decipher archetypal patterns, like a head and shoulder pattern, or doji’s or primary wave forms as in Elliott Wave theory and use with them other technical indicators such as a MACD or stochastic to determine future price movements. “Price discounts the market” is the embodiment of the technical analysis.
How Technicians analyze the market:
There are many types of charts that allow for technical analysis. Simple line charts, Point and Figure Charts, Candlestick charts are some of the methods of forecasting pricing movements. For example, below is an example of a Point And Figure Charting method. A Point and Figure chart is constructed so that an increase in price is denoted by an “X” and a price reduction is denoted by a “O” with price action not occurring below a certain threshold limit, let’s say 30 basis points. Therefore, this method of price action is analyzing the overall bullish or bearish momentum in the market. For example, the overall trend, as shown by the chart is bearish, which is manifested with the price action occurring below the 45-degree red dotted line. Had the price action been in the opposite direction, a pricing momentum reversal could have unfolded. Also a target of 1.01 has been initiated with a good risk reward ratio of 2.2, meaning that in due course there is a higher likelihood that this targeted Euro US dollar currency parity may be reached. A technical indicator, such as a MACD, can be used to supplement our understanding of the market momentum or relative strength of the short term over the long term. For example, the crossover of the signal line, which is the EMA (exponential moving average of MACD), through the MACD line (12 day EMA – 26 day EMA), would show how the relative strength or momentum of the price move is changing from the short term to the long term.
There is another reason to use price movement as the barometer of economies health. It has been witnessed that price acts as a leading indicator for the economy, given that expectation on the health of the economy or a security is constantly built into the price which manifests in discernable emergent patterns. Even if the market would move in a sudden knee jerk reaction to market news, it more often than not retraces back to its former state, if the long term move is not consistent with the sudden reaction of the market. Thus, technical analysis can be used to decide proper entry points. So if fundamental analysis may shed light on what to buy, technical analysis can state when to buy, given its nature to spot supply demand patterns, market sentiment changes, and break outs from pressure points.
Technical Analysis Vs. EMH:
Technical analysis contradicts with the tenets of Efficient Market Hypothesis (EMH), which states that “In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value. “Thus under EMH it is impossible to beat the market because efficiency in the market causes it to reflect all available information and thus any security, commodity or currency always trades at its fair value. This makes it impossible to purchase undervalued securities and sell them for inflated prices. In this is the implicit assumption that market participants are rational decision makers which is contradicted by technicians who state that people don’t act as rationally as EMH makes them out to be. Rather human behavior is influenced by emotions, cognitive errors, preferences and a herd mentality, which is a source to market volatility that results in almost predictive price pattern, open to correct interpretation. EMH advocates respond that, even if individual market participants don’t act rationally, but aggregate decisions seem to balance each other out, resulting in rational outcomes. Professor. Joseph Lawrence of Princeton concluded in 1929 that “the consensus of judgement of the millions whose valuations function on that admirable market, the Stock Exchange, is that stocks are not at present over-valued…….Where is that group of men with all-embracing wisdom which will entitle them to veto the judgement of the intelligent multitude.” On predictability Burton Malkei said, that “once such a regularity is known to market participants, people will act in such a way that prevents it from happening in the future.” In support to technical analysis, Andrew Lo analyzed data from 1962 to 1996 and showed that several technical indicators do provide “incremental information” with practical value.
Scientific Justification of Technical Analysis:
A general framework for analyzing efficacy of technical analysis has been established which seems to have statistical significance. The probabilistic model relies on the Froude number, which characterizes the relative strength of velocity or momentum and a time horizon forecast. Trend following and contrarian approaches appear to be applicable under this model as it exhibits significant predictive capability when tested under varying market phases. Caginalp and DeSantis, in a study analyzing 100,000 points demonstrated that trend following has similar importance as valuation, while volume and volatility also exhibit statistical significance. Their study shed light on behavioral finance, as it exhibited that positive trends tended to occur at 3.7 standard deviation was positively correlation with price increases. Conversely, during downtrends, buying on dips did not occur until the downtrend is at 4.6 standard deviation. This experimental approach exhibited that trend following, a form of technical analysis, was significant statistically, and lends credibility to this form of market analysis.
Technical Analysis Limitations:
Personal bias can affect quality of decision making. Traders need to remain wary of their personal bias as over bullishness or bearishness are emotions counterproductive for trading. Further chart reading is open to interpretation; potentially one chart can offer multiple scenarios to a host of investors, all with their own logical price forecast biases substantiated by supports and resistance levels. Technical analysis can also lead to ambivalence in investors when they exhibit inability to comprehend correctly the confluence of factors pointing the price movement to a residual direction. In such scenarios it becomes necessary to incorporate other forms of market reviews, such as fundamental analysis, to give credence to the technical outlook. This supplemental information thus helps in better discerning turning points in the market; thus in some cases technical analysis may be construed as an incomplete form of analysis.
Unlike fundamental analysis, technical analysts consider price movement to be a sum total of psychological responses of investors in the market using pricing patterns as pivots for decision making. Prices being fashioned by forces of demand and supply, with responses from the market place being non-random, emergent patterns open for subjective interpretation and extrapolation. Thus, the learning curve is steep because a degree of artistry is required in decoding pricing patterns and developing accurate forecasts.