TECHNICAL ANALYSIS

Technical analysis attempts to forecast future prices by the study of past prices and a few other related
summary statistics about security trading. A technical analyst is always concerned with the direction of
price movements. Demand and supply equation is the basis of Technical Analysis.

Technical analysis is a trading discipline employed to evaluate investments and identify trading
opportunities by analyzing statistical trends gathered from trading activity, such as price movement and
volume. Unlike fundamental analysts, who attempt to evaluate a security's intrinsic value, technical
analysts focus on patterns of price movements, trading signals and various other analytical charting tools
to evaluate a security's strength or weakness.

Technical analysis can be used on any security with historical trading data. This includes
stocks, futures, commodities, fixed-income, currencies, and other securities. In this tutorial, we’ll usually
analyze stocks in our examples, but keep in mind that these concepts can be applied to any type of
security. In fact, technical analysis is far more prevalent in commodities and forex markets
where traders focus on short-term price movements.

technical analysis is an analysis methodology for forecasting the direction of prices through the study of
past market data, primarily price and volume. Behavioral economics and quantitative analysis use many
of the same tools of technical analysis, which, being an aspect of active management, stands in
contradiction to much of modern portfolio theory. The efficacy of both technical and fundamental
analysis is disputed by the efficient-market hypothesis, which states that stock market prices are
essentially unpredictable.

A core principle of technical analysis is that a market's price reflects all relevant information impacting
that market. A technical analyst therefore looks at the history of a security or commodity's trading pattern
rather than external drivers such as economic, fundamental and news events. It is believed that price
action tends to repeat itself due to the collective, patterned behavior of investors. Hence technical analysis
focuses on identifiable price trends and conditions.
Market action discounts everything
Based on the premise that all relevant information is already reflected by prices, technical analysts believe
it is important to understand what investors think of that information, known and perceived.
Prices move in trend
Technical analysts believe that prices trend directionally, i.e., up, down, or sideways (flat) or some
combination. The basic definition of a price trend was originally put forward by Dow Theory
An example of a security that had an apparent trend is AOL from November 2001 through August 2002.
A technical analyst or trend follower recognizing this trend would look for opportunities to sell this
security. AOL consistently moves downward in price. Each time the stock rose, sellers would enter the
market and sell the stock; hence the "zig-zag" movement in the price. The series of "lower highs" and
"lower lows" is a tell tale sign of a stock in a down trend.[28] In other words, each time the stock moved
lower, it fell below its previous relative low price. Each time the stock moved higher, it could not reach
the level of its previous relative high price.
Note that the sequence of lower lows and lower highs did not begin until August. Then AOL makes a low
price that does not pierce the relative low set earlier in the month. Later in the same month, the stock
makes a relative high equal to the most recent relative high. In this a technician sees strong indications
that the down trend is at least pausing and possibly ending, and would likely stop actively selling the
stock at that point.
History tends to repeat itself
Technical analysts believe that investors collectively repeat the behavior of the investors that preceded
them. To a technician, the emotions in the market may be irrational, but they exist. Because investor
behavior repeats itself so often, technicians believe that recognizable (and predictable) price patterns will
develop on a chart.[10] Recognition of these patterns can allow the technician to select trades that have a
higher probability of success.[29]
Technical analysis is not limited to charting, but it always considers price trends.[1] For example, many
technicians monitor surveys of investor sentiment. These surveys gauge the attitude of market
participants, specifically whether they are bearish or bullish. Technicians use these surveys to help
determine whether a trend will continue or if a reversal could develop; they are most likely to anticipate a
change when the surveys report extreme investor sentiment.[30] Surveys that show overwhelming
bullishness, for example, are evidence that an uptrend may reverse; the premise being that if most
investors are bullish they have already bought the market (anticipating higher prices). And because most
investors are bullish and invested, one assumes that few buyers remain. This leaves more potential sellers
than buyers, despite the bullish sentiment. This suggests that prices will trend down, and is an example
of contrarian trading.
The Underlying Assumptions of Technical Analysis
There are two primary methods used to analyze securities and make investment decisions: fundamental
analysis and technical analysis. Fundamental analysis involves analyzing a company’s financial
statements to determine the fair value of the business, while technical analysis assumes that a security's
price already reflects all publicly-available information and instead focuses on the statistical analysis of
price movements. Technical analysis attempts to understand the market sentiment behind price trends by
looking for patterns and trends rather than analyzing a security's fundamental attributes.

Charles Dow released a series of editorials discussing technical analysis theory. His writings included
two basic assumptions that have continued to form the framework for technical analysis trading.

1. Markets are efficient with values representing factors that influence a security's price, but
2. Market price movements are not purely random but move in identifiable patterns and trends that
tend to repeat over time.3

The efficient market hypothesis (EMH) essentially means the market price of a security at any given point
in time accurately reflects all available information, and therefore represents the true fair value of the
security. This assumption is based on the idea that the market price reflects the sum total knowledge of all
market participants. While this assumption is generally believed to be true, it can be affected by news or
announcements about a security that may have varied short-term or long-term influence on a security’s
price. Technical analysis only works if markets are weakly efficient.

The second basic assumption underlying technical analysis, the notion that price changes are not random,
leads to the belief of technical analysts that market trends, both short-term and long-term, can be
identified, enabling market traders to profit from investing based on trend analysis.
Technical analysis is based on three main assumptions:

1: The market discounts everything

Many experts criticize technical analysis because it only considers price movements and ignores
fundamental factors. Technical analysts believe that everything from a company's fundamentals to broad
market factors to market psychology are already priced into the stock. This removes the need to consider
the factors separately before making an investment decision. The only thing remaining is the analysis of
price movements, which technical analysts view as the product of supply and demand for a particular
stock in the market.4

2: Price moves in trends

Technical analysts believe that prices move in short-, medium-, and long-term trend. In other words, a
stock price is more likely to continue a past trend than move erratically. Most technical trading strategies
are based on this assumption.4

3: History tends to repeat itself

Technical analysts believe that history tends to repeat itself. The repetitive nature of price movements is
often attributed to market psychology, which tends to be very predictable based on emotions like fear or
excitement. Technical analysis uses chart patterns to analyze these emotions and subsequent market
movements to understand trends. While many form of technical analysis have been used for more than
100 years, they are still believed to be relevant because they illustrate patterns in price movements that
often repeat themselves.4

How Technical Analysis Is Used

Technical analysis attempts to forecast the price movement of virtually any tradable instrument that is
generally subject to forces of supply and demand, including stocks, bonds, futures and currency pairs. In
fact, some view technical analysis as simply the study of supply and demand forces as reflected in the
market price movements of a security. Technical analysis most commonly applies to price changes, but
some analysts track numbers other than just price, such as trading volume or open interest figures.

Across the industry there are hundreds of patterns and signals that have been developed by researchers to
support technical analysis trading. Technical analysts have also developed numerous types of trading
systems to help them forecast and trade on price movements. Some indicators are focused primarily on
identifying the current market trend, including support and resistance areas, while others are focused on
determining the strength of a trend and the likelihood of its continuation. Commonly used technical
indicators and charting patterns include trend lines, channels, moving averages and momentum indicators.

In general, technical analysts look at the following broad types of indicators:

 Price trends
 Chart patterns
 Volume and momentum indicators
 Oscillators
 Moving averages
 Support and resistance levels

The Difference between Technical Analysis And Fundamental Analysis

Fundamental analysis and technical analysis, the major schools of thought when it comes to approaching
the markets, are at opposite ends of the spectrum. Both methods are used for researching and forecasting
future trends in stock prices, and like any investment strategy or philosophy, both have their advocates
and adversaries.

Fundamental analysis is a method of evaluating securities by attempting to measure the intrinsic value of
a stock. Fundamental analysts study everything from the overall economy and industry conditions to the
financial condition and management of companies. Earnings, expenses, assets and liabilities are all
important characteristics to fundamental analysts.

Technical analysis differs from fundamental analysis in that the stock's price and volume are the only
inputs. The core assumption is that all known fundamentals are factored into price; thus, there is no need
to pay close attention to them. Technical analysts do not attempt to measure a security's intrinsic value,
but instead use stock charts to identify patterns and trends that suggest what a stock will do in the future.

Limitations of Technical Analysis

The major hurdle to the legitimacy of technical analysis is the economic principle of the efficient markets
hypothesis. According to the EMH, market prices reflect all current and past information already and so
there is no way to take advantage of patterns or mispricing to earn extra profits, or alpha. Economists and
fundamental analysts who believe in efficient markets do not believe that any actionable information is
contained in historical price and volume data, and furthermore that history does not repeat itself; rather,
prices move as a random walk.

A second criticism of technical analysis is that it works in some cases but only because it constitutes a
self-fulfilling prophesy. For example, many technical traders will place a stop-loss order below the 200-
day moving average of a certain company. If a large number of traders have done so and the stock reaches
this price, there will be a large number of sell orders, which will push the stock down, confirming the
movement traders anticipated.

Then, other traders will see the price decrease and also sell their positions, reinforcing the strength of the
trend. This short-term selling pressure can be considered self-fulfilling, but it will have little bearing on
where the asset's price will be weeks or months from now. In sum, if enough people use the same signals,
they could cause the movement foretold by the signal, but over the long run this sole group of traders
cannot drive price.

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