Technical analysis

In the fast-paced world of financial markets, it is important to develop domain knowledge expertise in quantitative and qualitative analytical skills. Increasing volatility across global markets has necessitated a multidimensional approach for understanding the importance of Technical Analysis for predicting market movements.

Given the current market scenario and dynamism, Technical Analysis has attracted attention more than ever before. The concepts are multi-fold and are applicable across all financial markets: equities, fixed income, currencies, futures, and options— domestic or global. Technical Analysis offers a concrete understanding of how to chart market movements and benefit from forecasting the same.

About Technical Analysis

The importance of Technical Analysis is five-fold. While Fundamental Analysis helps in gauging the demand-supply situations, price earnings ratios, economic statistics, and so forth, there is no psychological component involved in such analysis. Yet, many a time, the markets are influenced, to a major extent, by emotionalism. An ounce of emotion can be worth a pound of facts. Technical Analysis is security analysis for forecasting the future direction of prices through the study of past market data, primarily price and volume. The basic assumption behind Technical Analysis is ‘History Keeps Repeating Itself’, which attempts to understand the emotions in the market by studying the market itself.

Human element  

The price of a security represents a consensus. It is the price at which one person agrees to buy and another agrees to sell. The price at which an investor is willing to buy or sell depends primarily on his expectations. If he expects the security’s price to rise, he will buy it; if the investor expects the price to fall, he will sell it. These simple statements are the cause of a major challenge in forecasting security prices, because they refer to human expectations. As we all know firsthand, humans are not easily quantifiable nor predictable. This fact alone will keep any mechanical trading system from working consistently.

Fundamental analysis

If we were all totally logical and could separate our emotions from our investment decisions, then, fundamental analysis the determination of price based on future earnings, would work magnificently. And since we would all have the same completely logical expectations, prices would only change when quarterly reports or relevant news was released. Investors would seek “overlooked” fundamental data in an effort to find undervalued securities. The hotly debated “efficient market theory” states that security prices represent everything that is known about the security at a given moment. This theory concludes that it is impossible to forecast prices, since prices already reflect everything that is currently known about the security.

Technical Analysis in the Foreign Exchange Market

Technical analysis, which dates back a century to the writings of Wall Street Journal editor Charles Dow, is the use of past price behavior to guide trading decisions in asset markets. For example, a trading rule might suggest buying a currency if its price has risen more than 1 percent from its value five days earlier. Such rules are widely used in stock, commodity, and (since the early 1970s) foreign exchange markets. More than 90 percent of surveyed foreign exchange dealers in London report using some form of technical analysis to inform their trading decisions (Taylor and Allen, 1992). In fact, at short horizons—less than a week—technical analysis predominates over fundamental analysis, the use of other economic variables like interest rates, and prices in influencing trading decisions.

The methods used to analyze securities and make investment decisions fall into two very broad categories: fundamental analysis and technical analysis. Fundamental analysis involves analyzing the characteristics of a company in order to estimate its value.

Technical analysis  studies supply and demand in a market in an attempt to determine what direction, or trend, will continue in the future.

Technical analysis is the study of financial market action. The technician looks at price changes that occur on a day-to-day or week-to-week basis or over any other constant time period displayed in graphic form, called charts. Hence the name chart analysis. A chartist analyzes price charts only, while the technical analyst studies technical indicators derived from price changes in addition to the price charts. Technical analysts examine the price action of the financial markets instead of the fundamental factors that (seem to) effect market prices. Technicians believe that even if all relevant information of a particular market or stock was available, you still could not predict a precise market “response” to that information. There are so many factors interacting at any one time that it is easy for important ones to be ignored in favor of those that are considered as the “flavor of the day.” The technical analyst believes that all the relevant market information is reflected (or discounted) in the price with the exception of shocking news such as natural distasters or acts of God. These factors, however, are discounted very quickly.

Technical analysis is the use of past price behavior and/or other market data, such as volume, to guide trading decisions in asset markets. These decisions are often generated by applying simple rules to historical price data. A technical trading rule (TTR), for example, might suggest buying a currency if its price has risen more than 1% from its value five days earlier. Traders in stock, commodity and foreign exchange markets use such rules widely. Technical methods date back at least to 1700, but the “Dow Theory,” proposed by Wall Street Journal editors Charles Dow and William Peter Hamilton, popularized them in the late nineteenth and early twentieth centuries  Technical analysts—who often refer to themselves as “technicians”—argue that their approach allows them to profit from changes in the psychology of the market. The following statement expresses this view: The technical approach to investment is essentially a reflection of the idea that prices move in trends which are determined by the changing attitudes of investors toward a variety of economic, monetary, political and psychological forces…Since the technical approach is based on the theory that the price is a reflection of mass psychology (“the crowd”) in action, it attempts to forecast future price movements on the assumption that crowd psychology moves between panic, fear, and pessimism on one hand and confidence, excessive optimism, and greed on the other. (Pring (1991, pp. 2-3))

Although modern technical analysis was originally developed in the context of the stock market, its advocates argue that it applies in one form or another to all asset markets. Since the era of floating exchange rates began in the early 1970s, foreign currency traders have widely adopted this approach to trading. At least some technicians clearly believe that the foreign exchange market is particularly prone to trending. Currencies have the tendency to develop strong trends, stronger than stocks in my opinion because currencies reflect the performance of countries. (Jean-Charles Gand, Société Générale Gestion, in Clements (2010 p. 84))

It has been our longstanding experience that nothing trends as well or as clearly as a major currency market — not equity market indices, not commodity markets and not even long-term Treasuries. (Walter Zimmermann, United-ICAP, in Clements (2010 p. 197))

Academic research on the profitability of technical analysis tends to confirm the idea that foreign exchange markets trend particularly well. After reviewing the literature on technical analysis in a variety of markets, Park and Irwin (2007) conclude that technical analysis is profitable in foreign exchange and commodity futures markets but not in stock markets (also, see Silber (1994)).

Types of Technical Analysis

There are many types of technical analysis and many ways to map current and past price and volume data into trading decisions. Broadly speaking, technicians have traditionally employed two types of analysis to distinguish trends from shorter-run fluctuations and to identify reversals: charting and mechanical (or indicator) methods. Charting, the older of the two methods, involves graphing the history of prices over some period— determined by the practitioner—to predict future patterns from past patterns. Charting is a very subjective system that requires the analyst to use judgment and skill in finding and interpreting patterns. Mechanical rules (i.e., indicators), on the other hand, impose consistency and discipline on the technician by requiring him to use rules based on mathematical functions of present and past exchange rates.

What is technical analysis, and how can it help my investing?

If you have ever bought a stock, bond, or mutual fund only to watch it go down and then vowed to sell it once you “broke even,” you might benefit from learning more about how technical analysts evaluate the markets. A “technician,” also popularly—but narrowly—known as a “chartist,” looks to take the emotion out of investing by applying rules that usually apply to almost every investment that fluctuates in price in a free market.

A fundamental analyst looks at the assets, profits, and the business trends of a company and derives an estimate of fair value for the stock. If the stock price is lower than this expected value, the stock should be bought. If the stock is trading higher than what the fundamental analyst believes it to be worth, the stock should either not be bought or sold. The problem with focusing only on valuations is that overvalued stocks can get more over-valued and undervalued stocks can stay undervalued.

Very often, technical analysts will skip analyzing the company’s prospects and values and assume that the market is doing that for them because the stock price reflects everything already publicly known and expected about the company and its prospects. Technical analysis, instead, seeks to forecast future prices of investments and markets by analyzing past trading action. In general, a technician believes that people have predictable mental short cuts of reacting to action in the markets (known as heuristics in cognitive psychology). Technicians seek to profit by anticipating the mass psychological biases of buyers and sellers in a broad range of markets.

What are some examples of technical analysis in action? Financial news networks and investors quoted in newspapers and magazines often talk about “support and resistance levels”. A support level is where a stock or even a stock market stopped a decline and reversed direction back up, often on higher than average volume. The support level is believed to be a price where investors stand ready to buy after a decline. A resistance level is the opposite: a stock or market goes up to a certain price and then stalls or declines. Technicians use these levels frequently to determine attractive buying and selling points. The higher the volume at a turning point, the more potent the support or resistance becomes. Another powerful technical tool is trend analysis. Technicians believe that a trend is expected to continue unless significant evidence indicates otherwise. In other words, cut your losses short and let your winners run. This runs contrary to human instinct; most investors are happy to take almost any profit while waiting for their losers to turn around. And if that loser does go up, they might quickly sell it at break-even rather than waiting to see if it can turn into a profit!

History of technical analysis

The history of technical analysis of financial markets and security prices dates back over 200 years to when Japanese nobility traded paper coupons against future rice harvests. The rice coupons’ price often changed rapidly even when there was no change in the weather or any news about the size of the expected harvest. These changes in price were captured on charts, and these charts were studied very carefully. Eventually, traders began to use chart patterns to anticipate a change in price.

Since then, markets have become larger and global in scope, new ways to trade securities have been introduced, and the number of securities and derivatives has exploded. Yet, the basic tenets of technical analysis endure: prices change because of the fear and greed that investors were born with, and by focusing on indicators of this fear or greed a technician can form an actionable plan to invest, whether for the very short term or the very long.