INTRODUCTION

Meaning of Technical Analysis

A method of evaluating securities by analyzing statistics generated by market activity, such as
past prices and volume. Technical analysts do not attempt to measure a security's intrinsic
value, but instead use charts and other tools to identify patterns that can suggest future
activity.
Technical analysis is the study of past price and activity history from charts in order to predict
future price movements. The art of technical analysis is to identify patterns in price
movements that will then dictate where that market is moving to in the future.
It must be remembered and more importantly understood that the market is not just a number
of shares of different companies moving in one direction or another. The market is a number
of human beings moving the price of those shares in one direction or another. People make
the market change, when they demand more of one share or less of another. This is what
moves the price. One may feel that a share price in an individual company has gone up
because it has posted a large gain in profits that year. It hasnt. The price of the share has
gone up because based on that profit news more people wanted to buy that share. The human
beings demanding that share have forced the price up. This concept is crucial to your
understanding of technical analysis.
Human nature remains more or less constant and tends to react to similar situations in
consistent ways. By studying the nature of previous market turning points, it is possible to
identify certain patterns to develop an understanding of where the market is going to move in
the future. Technical analysis therefore is based on the assumption that people will continue
to make the same mistakes that they made in the past. Human relationships are extremely
complex and never repeat in identical combinations. The markets, which as explained are a
reflection of people in action, never duplicate their performance exactly, but the recurrence of
similar characteristics is sufficient to enable market watchers to identify major junction, or
turning points.
Philosophy/Rational behind technical analysis
There are three premises on which technical analysis is based:
a. History Repeats Itself
b. Prices Move In Trends
c. Market Action Discounts Everything
a. History Repeats Itself
Much of the body of technical analysis and the study of market action has to do with the
study of human psychology. Chart patterns, for example, which have been identified and
categorised over the past 100 years, reflect certain standard pictures that appear on price
charts. These pictures reveal the bullish or bearish psychology of the market. Since these
patterns have worked well in the past, it is assumed that they will continue to work well in the
future.
Another way of expressing this premise is that the key to understanding the future lies in the
study of the past, or that future is just a repetition of the past.
Prices move in trends
The concept of a trend is absolutely essential to the technical approach. Here again, unless
one accepts the premise that markets do in fact trend, there is no point in reading any further.
The whole purpose of charting the price action of a market is to identify trends in the early
stages of their development and ride on that trend.
Furthermore, it is important to realise that a trend in motion is more likely to continue than
reverse. A trend will continue until it changes course. This sounds a very obvious concept, but
then this is what we are trying to achieve. We are looking for the most probable movement of
a market. If the market is going up, it will continue going up until it reverses. If we can

identify that market is going up, then we will buy the product until this identification tells us
otherwise.
Market action discounts everything
This statement forms what is probably the cornerstone of technical analysis. Unless this
premise is understood and accepted then nothing else really makes sense. The technical
analyst believes that everything that could affect the price fundamental, political,
psychological or otherwise is already reflected in the price of that product. It follows
therefore, that analysing companys profit forecasts is useless, as the market has already
priced that into the value of the share. All that is needed therefore is a study of the price
action. While this claim appears at first hand to be rather fantastical and unbelievable, it is
hard to disagree with if one takes time to consider its true meaning.
As a rule, chartists do not concern themselves with the reasons why prices rise or fall. Very
often, in the early stages of a price trend or at critical turning points, no one seems to know
exactly why a market is performing in a certain way. This doesnt matter to a chartist, as he
will just look to follow this trend. He knows there are reasons why the market has gone up or
down, but he just doesnt believe that knowing what those reasons are is necessary to the
forecasting of that price.
It follows then that if everything that affects the market price is ultimately reflected in the
market place, then all that is necessary is the study of the price action, not why it moved. By
studying price charts and a host of other technical indicators, the chartist in effect lets the
market tell him which way it is most likely to go.
Another very important thing that must be borne in mind when discussing technical analysis
is that the practice of it is self-fulfilling. There are many millions of traders that treat
technical analysis as a religion. When the chart pattern indicates they should buy, they will
buy. If it indicates that they should sell, they will sell. If many millions are following the
same pattern, the price will do exactly what they thought it would because they are all doing
it. If everyone looked at a chart and decided at some point the market would go up. They
would all buy it at this point. As they are all buying it at this point, the market will go up, as
demand factors on that product will be greater than supply. There are a million technical
analysts all buying at this level. We may as well join them.
Technical analysts use dozens of different quantitative metrics in order to predict stock prices.
In this section, well introduce you to some of the most popular ones and explain to you what
theyre all about, but first here are a few key terms you should know about:

Support Level: The level that the technical analyst believes a stock price will not fall
below (also sometimes called a floor)

Resistance Level:

The

opposite

of

support

level,

the

level

that

the

technical analyst believes a stock price will not exceed.

Breakout: If a stock surpasses the resistance level or falls below the support level, it is
said to be a breakout.

Advance-Decline Line: The total number of advancing issues minus the total number
of declining issues, added to a cumulative total.

Moving Averages
Perhaps the most commonly used variable in technical analysis, the moving average for a
stock is the average selling price for the stock over a set period of time (the most common
being 20, 30, 50, 100 and 200 days). Moving average data is used to create charts that show
whether or not a stocks price is trending up or down. They can be used to track daily, weekly,
or monthly patterns. Each new days (or weeks or months) numbers are added to the average
and the oldest numbers are dropped; thus, the average moves over time. In general, the
shorter the time frame used, the more volatile the prices will appear, so, for example, 20 day
moving average lines tend to move up and down more than 200 days moving average lines.
Relative Strength
Technical analysts use what is called relative strength in order to compare the price
performance of one stock to the entire market. The relative strength of a stock is calculated by
taking the percentage price change of a stock over a set period of time and ranking it on a
scale of 1 to 100 against all other stocks on the market. For example, a stock with a relative
strength of 90 has experienced a greater increase in its price over the last year than the price
increases experienced by 90% of all other stocks on the market. Some technical analysts like
stocks with high relative strength rankings, believing that stocks which have recently gone up
are more likely to continue going up. Other technical analysts believe that a very high relative
strength can be an indication that the stock is overbought and is ready to fall. Relative
strength is really a rear view window metric, measuring only how the stock has done in the
past, not how it will do in the future.
Momentum
Momentum investors seek to take advantage of upward or downward trends in stock prices or
earnings. They believe that these stocks will continue to head in the same direction because
of the momentum that is already behind them. The idea relies on the belief that there are a
large number of lemmings in the market who will buy whatever stock is already hot.
Momentum investors do not necessarily believe that momentum stocks will do well in the
long run, but they do think that in the short run people will continue to buy them as they have
in the immediate past. This therefore involves a lot of market timing which of course entails a
substantial amount of risk . Both moving averages and relative strength can be used in order
to determine momentum.
Charts
Charts are the main tool that technical analysts use in order to plot their data and predict
prices. Technical analysts may use several different types of charts in order to conduct their
tests, including line charts, bar charts, and candlestick charts. Most of the time, analysts use

these charts in order to look for patterns in the data. Some of the more commonly used
patterns include:

Cup and Handle: A pattern on a bar chart that is in the shape of the letter U over a
period of between 7 and 65 weeks. Once the stock price reaches the second peak of
the U, technical analysts believe that the price will fall as investors who bought at
the previous peak start to unload their shares.

Head and Shoulders: A chart formation in which a price exhibits three

successive rallies, the second one being the highest. The name derives from
the fact that on a chart the first and third rallies look like shoulders and the second
looks like a head. Some technical analysts consider it a sign that the stock will fall
further.

Double Bottom: A chart formation that looks like a W. Technical analysts aim to
buy at one of the troughs and ride the stock higher.

Bollinger Bands
Bollinger bands on a chart have three lines in them: an upper band, a lower band, and a band
at the moving average. The upper and lower bands are placed precisely at two standard
deviations above the moving average and two standard deviations below the moving average
respectively (standard deviation is a mathematical measure of volatility). Bollinger bands will
expand and contract as the market for the stock becomes more or less volatile. If the stock
price reaches the upper band, then the stock is thought to be overbought; if it reaches the
lower band, then it is thought to be oversold.
Characteristics of Technical Analysis:
Technical analysis employs models and trading rules based on price and volume
transformations, such as the relative strength index, moving averages, regressions, intermarket and intra-market price correlations, business cycles, stock market cycles or,
classically, through recognition of chart patterns.
Technical analysis stands in contrast to the fundamental analysis approach to security and
stock analysis. Technical analysis analyzes price, volume and other market information,
whereas fundamental analysis looks at the facts of the company, market, currency or
commodity. Most large brokerage, trading group, or financial institutions will typically have
both a technical analysis and fundamental analysis team.
Technical analysis is widely used among traders and financial professionals and is very often
used by active day traders, market makers and pit traders. In the 1960s and 1970s it was
widely dismissed by academics. In a recent review, Irwin and Park ] reported that 56 of 95
modern studies found that it produces positive results but noted that many of the positive
results were rendered dubious by issues such as data snooping, so that the evidence in support
of technical analysis was inconclusive; it is still considered by many academics to
be pseudoscience.[15] Academics such as Eugene Fama say the evidence for technical analysis

is sparse and is inconsistent with the weak form of the efficient-market hypothesis. Users
hold that even if technical analysis cannot predict the future, it helps to identify trading
opportunities.
In the foreign exchange markets, its use may be more widespread than fundamental
analysis. This does not mean technical analysis is more applicable to foreign markets, but that
technical analysis is more recognized as to its efficacy there than elsewhere. While some
isolated studies have indicated that technical trading rules might lead to consistent returns in
the period prior to 1987, most academic work has focused on the nature of the anomalous
position of the foreign exchange market. It is speculated that this anomaly is due to central
bank intervention, which obviously technical analysis is not designed to predict. Recent
research suggests that combining various trading signals into a Combined Signal Approach
may be able to increase profitability and reduce dependence on any single rule.[

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