- What is Technical Analysis
- Principles of Technical Analysis
- Advantages of Technical Analysis
- Criticisms of Technical Analysis
- The Dow Theory
Technical Analysis Definition
Principles of Technical Analysis
Market Action Discounts Everything
- All Economic, Political, Social and Psychological factors (the fundamentals) are reflected in the price
- The price also includes the hidden fundamentals
- If prices are rising it means demand is greater than supply
- If prices are falling it means supply is greater than demand
- “Buy the rumor and sell the fact”
Prices Move in Trends
History Repeats Itself
- Investor’s behavior tends to repeat itself over time
- Identifiable price patterns can be studied to predict similar future patterns
- Greed and fear have been showing up at market tops and bottoms forever
- Basic human psychology does not change
- Patterns which worked in the past will work in the future
Advantages of Technical Analysis
- Flexibility and adaptability
- Applies to different trading mediums
- Applies to different time dimensions
- Plays a role in economic forecasting
Flexibility and Adaptability
- Chartists can easily follow many markets , which is generally not true of the fundamentalists who tend to specialize in one group of assets
- Technicians can rotate attention and capital in order to take advantage of the rotational nature of the markets
- A trending phase is usually followed by a trendless period while at the same time another market will be experiencing a major trend
Different Trading Mediums
Because it is based on the study of price action, technical analysis applies to different trading mediums
- Stocks
- Commodities
- Forex / Currencies
- Bonds
Different Time Dimensions
- Technical analysis applies to different time frames
- Short term – Hourly charts
- Medium term – Daily Charts
- Long Term – Weekly Charts
- The opinion that technical analysis should be used only for the
- short term is NOT true
Economic Forecasting
- The charts of commodities can indicate the strength or weakness of the economy as well as the direction of inflation
- Rising commodity prices suggest a stronger economy and a rise in inflation
- Falling commodity prices warn for a slowing economy and a drop in inflation
- Interest rates are generally positively correlated with commodity prices and inflation and inversely correlated with bonds
- The U.S dollar and other currency futures also provide early guidance about the strength or weakness of the respective economy
Criticism of Technical Analysis
- Self-fulfilling prophecy
- The past cannot predict the future
- Efficient market hypothesis
- Random walk theory
Self-Fulfilling Prophecy
- The use of price patterns has been widely publicized
- Traders are familiar with these patterns and act on them in concert
- This creates a “Self – Fulfilling Prophecy”
- Technicians debunk this myth by confirming that they only trade after the completion of the pattern
- Markets are driven by supply and demand, technicians’ actions only distort them temporarily
The Past Cannot Predict the Future
- Can the past predict the future?
- Critics of technical analysis often raise this question
- In every statistical analysis the past is used to predict the future –This is true for economic, fundamental and technical analysis
- Analysts can only estimate the future by projecting past experiences into the future
- The use of past price data to predict the future is based on sound statistical concepts – descriptive and inductive statistics
Efficient Market Hypothesis
- Efficient Market Hypothesis holds that prices fluctuate randomly about their intrinsic value
- It also holds that the best market strategy to follow would be a “buy and hold” as opposed to any attempt to “beat the market”
- It assumes that existing prices already incorporate the news and data that comes to everyone at the same time
- The basis of technical forecasting is that important market information is discounted in the market price long before it becomes known
Random Walk Theory
- It claims that price changes are “serially independent” and that price history is not a reliable indicator of future price direction
- Price movement is random and unpredictable
- All markets exhibit a certain amount of randomness or “noise” but to believe that all price movement is random, is unrealistic
- Price movement appears random to those who have not taken the time to study the rules of market behavior
- Empirical observation shows that prices DO trend
Dow Theory
- Charles Henry Dow (1851 –1902) was an American journalist who co-founded Dow Jones & Co. with Edward Jones and Charles Bergstresser
- Dow also founded ‘The Wall Street Journal’ and invented the ‘Dow Jones Industrial Average’
- He developed principles for analyzing market behavior which later became known as ‘Dow Theory’, the groundwork for technical analysis
- William Peter Hamilton, Robert Rhea and E. George Schaefer organized and represented “Dow Theory,” based on Charles Dow’s editorials
- Dow Theory has six basic tenets or principles as summarized by Hamilton, Rhea and Schaefer
1- The Market has Three Movements
- The main movement lasts for more than a year, and possibly several years
- The secondary movement usually lasts between three weeks to six months
- The minor movement lasts less than three to four weeks
2- The Market has Three Phases
Accumulation Phase
- “Smart money” begins to accumulate stocks
Public Participation Phase
- Trend followers and professionals start to participate
Distribution Phase
- The public is fully involved but “Smart money” sells
3- The Averages Discount Everything
- Everything there is to know is already reflected in the markets through the price
- Prices reflect all the hopes, fears and expectations of all market participants
- Interest rate movements, earnings expectations, revenue projections, political elections and all else are already priced
4- Averages Must Confirm Each Other
- In order for a primary trend signal to be valid, all averages must confirm each other
- If one average records a new high / low, then the other must soon follow for the signal to be valid
5- Volume Must Confirm the Trend
- Volume should increase in the direction of the trend
- In an uptrend, volume should increase as prices move higher, and decrease as prices fall
- In a downtrend, volume should increase as prices fall, and decrease as prices move higher
- Volume should always increase during directional waves, and decrease on corrective waves
6- A Trend is More Likely to Continue than to Reverse
- A trend is assumed to be in effect until it gives a clear signal that it has reversed
- “The trend is your friend”
- “Never go against the trend”
- By following trends over different time frames traders can increase their profit making opportunities
Technical vs. Fundamental
- Fundamental analysis is the study of factors that affect an economy, market or asset class in order to find its intrinsic or fair value
- At the macro level, analysis examines interest rates, inflation, rate of growth, employment, politics, and national sentiment
- At the micro level, analysis examines financial statements, company accounts, cash flows, debt, and liquidity levels
- If this intrinsic value is under the current market price, then the security is overpriced and should be sold and vice versa
- Intrinsic Value = 1.30
- If price < Intrinsic value – Fundamentalists buy on the way down
- If price > Intrinsic value – Fundamentalists sell on the way up
- Technicians only buy after a reversal ie: On the way up
- Technicians only sell after a reversal ie: On the way down
- It is only at critical turning points where the two approaches disagree
- Fundamentalists cannot explain the factors behind new market movements at the beginning of an important market trend
- Price tends to lead the known fundamentals
- Major bull and bear markets in history have begun with little or no change in the fundamentals at all
- Since fundamentals are directly discounted and reflected in the price, then the study of fundamentals is deemed unnecessary
- Thus, chart reading is considered as a shortcut to fundamental analysis
- However, the opposite is not true as fundamental analysis does not include a study of price action
- Even if fundamental analysis is employed, the timing of market entry and exit has to rely on technical principles
- When both approaches disagree, use technical analysis
