Technical analysis is a tool that financial analysts use to forecast movement in the prices of securities, stocks and the market as a whole. While there are some who believe that the stock market has absolutely no predictably, fitting the efficient market hypothesis, those who have found success with technical analysis laud the usefulness of following trends in price movement.

History

Even though many technical analysis tools use today's latest technology, the ideas behind it go all the way back to the 1600s in the accounts that Joseph de la Vega made of Dutch markets. Homma Munehisa developed a form of technical analysis in the 1700s, and Richard W. Schabacker published some books in the 1920s and 1930s on the topic. Technical Analysis of Stock Trends, by Edwards and Magee, came out in 1948, and is still one of the most influential books in the field. While the focus in those days was on following charts rather than using computers to crunch the numbers, the theory has remained largely unchanged in the decades since.

Technical analysis goes way back to the 1600s and is used to forecast future price movement through the analysis of charts, patterns, indicators and historical price action.

General overview

Technical analysis involves the search for patterns in price charts, like the "head and shoulders" pattern. They look for patterns of resistance and/or support that fit within reasonably predictable channels, although some more arcane patterns include pennants, flags, and cup-and-handle trends. Technical analysts use other market indicators as well—such as data about advances and declines—in addition to volume up and down. The purpose of these indexes is to show whether the asset is trending or not, and the reliability of that trend. Some other metrics that technical analysts use include relative-strength index and moving averages. Bear/bull ratios, put/call ratios, implied volatility and short interest are also useful numbers.

Technical analysts have a variety of techniques at their disposal, and some choose one to use exclusively, while others use varieties to form their own hybrid strategies. Dow Theory, Elliott Wave Theory, and candlestick charting are the three most commonly used. The choice among methods is sometimes subjective and at other times logical, depending on the analyst and the situation.

A different type of analysis is fundamental analysis. While technical analysis looks at trends, fundamental analysis examines economic factors that have an effect on the way the markets move. Technical analysts believe that prices have an effect on built-in economic factors; this means that traders who use trend analysis will also look at economic effects.

Technical analysts use wide ranges of techniques to predict future price movement. Some choose to stick to one method, like price patterns, while others mix various methods such as combining technical indicators and price patterns together.

Characteristics of technical analysis

As recently as the 1970s, academics in finance looked down on technical analysis, although today it is a popular tool for market makers, day traders, and pit traders. A recent literature review found that a majority of researchers obtain positive results from technical analysis, but such problematic factors as data snooping mean that the evidence supporting the use of technical analysis remains unconvincing. Even today, many financial academics believe technical analysis to be little more than pseudoscience. However, those who support the use of technical analysis point to the fact that it identifies trading opportunities.

Technical analysis is more popular in the foreign exchange (forex) market, as more finance professionals recognize its effectiveness in evaluating currency trends. However, the role of intervention by central banks, which no methodology can predict, makes any sort of forex analysis a bit problematic.

Some financial academics believe that technical analysis does not adhere to a scientific method; however, it is widely used in the forex markets in order to identify potential trading opportunities.

Principles of technical analysis

One central tenet of technical analysis is that a market price is a reflection of all of the available information out there, and so technical analysts look at a security's pattern of trading over time. As investors collectively follow a trend toward patterns of behavior, price action will repeat itself over time. This is what makes conditions and trends the focus of technical analysis.

Principle #1: Trends move prices

Proponents of technical analysis assert that prices trend in a single direction (up, down, or flat) or some blend of the three. One example of this would be the trend of AOL’s stock price between the fall of 2001 and the summer of 2002. Whenever the stock would go up, some sellers would shed their stock, making the price zigzag. As highs and lows both dropped lower, the stock moved down over time. It was not until the highs stopped getting lower that investors began to think that AOL's price trend was turning around, bringing more buyers back into the market for this stock.

Principle #2: History actually repeats itself

Technical analysis centers around the idea that investors will, as a group, repeat the actions of the investors that came before them. Because this takes place so frequently, technical analysts believe that patterns of price will develop in a recognizable way on a price chart. It is the use of those patterns that gives the analyst the chance to enjoy a higher chance of success.

Not all technical analysis involves price charts, though. A lot of analysts take a look at investor-sentiment surveys, which are designed to gauge whether participants in the market are thinking more like bulls or bears. The analysts who use these surveys want to determine whether a trend will keep going or will undergo a reversal. When investor feeling is at an extreme, attitudes are more likely to portend a coming change. One common example happens when surveys are showing extreme levels of bearishness; this is often a sign that a downward trend is about to go the other way because investors are showing bearish attitudes as a result of their prior transactions. Because most investors are bearish and have sold, the assumption is that few sellers are left, leaving more possible buyers than sellers in the market. This would be an example of contrarian trading, suggesting that prices are about to trend up.

There are two main principles in technical analysis: trends move price direction, and historical price action tends to repeat itself. Another form of technical analysis is analyzing investor sentiment, as it can indicate whether a trend will keep going or reverse its behavior.

Bottom Line

Technical analysis is a tool to consider when you’re deciding on your own investment strategy. It takes the emotion out of investment decisions, because you’re just looking at trends on a chart as opposed to applying your own opinions about the economy to the price of a particular security. Technical analysis, just like other strategies for predicting market conditions, is one weapon that you have at your disposal to turn profits.

Summary:

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Technical analysis goes way back to the 1600s and is used to forecast future price movement through the analysis of charts, patterns, indicators and historical price action.

 

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Technical analysts use wide ranges of techniques to predict future price movement. Some choose to stick to one method, like price patterns, while others mix various methods such as combining technical indicators and price patterns together.

 

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Some financial academics believe that technical analysis does not adhere to a scientific method; however, it is widely used in the forex markets in order to identify potential trading opportunities.

 

P

There are two main principles in technical analysis: trends move price direction, and historical price action tends to repeat itself. Another form of technical analysis is analyzing investor sentiment, as it can indicate whether a trend will keep going or reverse its behavior.

 

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