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What is technical analysis?

Technical analysis Overview

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Technical analysis is the study of behaviour of market participants, as reflected in price movement & volume for a financial market, in order to identify stages in the development of price trends. Technical analysis can be used to assist in the decision making process in investing or trading in financial markets. Primarily, it is used to confirm the timing for an investor or trader to confirm:

  • Initial price trend identification
  • Trend status and potential entry points
  • Trend completion
  • Exit/reverse open trading position

 

Key priciples underpinning technical analysis


Technical analysis can be summarized into three underlying principles in regards to how financial markets operate:

  1. Market price discounts everything
  2. Prices move in trends some of the time
  3. Human nature is repeatable

Market Price discounts everything

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Information has a significant influence on market participants, irrelevant of the information being published or not. In addition, the future expectations of a financial market is also factored into the behaviour of the market participants. Thus, all factors that influence price have already impacted on price and the ability for market participants to act upon them. This can include, either trading decisions, psychological influences (i.e. aspirations, fears & desires) and financial resources.

The technical analysist trader does not get consumed in the reasons surrounding prices movements (rises & falls) due to the assumption that market participants act upon information or expectations. This is not suggesting inside training is responsible, but rather how information (published or unpublished) is interpreted & analysed to provide better insights into potential outcomes. Thus, price tends to be a leading indicator of published information due to what can be ascertained through interpolation & extrapolation or information & expectations.

Based on this premise, predictions can be made on the patterns that the market participants leave through historical trades which can be visualised via charts. Hence, these patterns represent previous traders & investors response to their information and expectations.

Prices move in trends some of the time

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Technical analysis theory suggests that the markets are not always efficient whereby information may not always be discounted immediately. Thus, if prices are not always efficient, then prices may not always be random to the extent where it may be possible to profit from price movement. Market efficiency will tend to vary across different markets and timeframes, however, shorter timeframes tend to be more inefficient the longer timeframes due to the nature information adsorption and the fact that the perception of market participants develop over time. In addition, trader/investors may not always act rationally contrary to the efficient market hypothesis.

The efficiency of the market can often be reflected through the speed of movement (large price change) rather than a subtle trend (small price movement over time). For example, a FOREX market may tend to absorb information quickly due to the information impact, scale of trade & breadth of market participation as opposed to a single stock with a reduced value, market participants and variation in information flow. Many trends do exhibit a step-like pattern which have a tendency to be less manipulated and easier to trade. Only in very efficient markets, where many people are watching as news comes out, do prices adjust quickly. Fast adjustments also occur when an announcement is made that is news to everyone such as a takeover. Prices also adjust gradually as more and more people hear news and also, very importantly, because everyone tends to have a different tolerance for risk. Price will often adjust gradually due to the market participants wanting to enter at the lowest price possible (and to prevent a premature inflation of prices), align to current market depth and to shield attention from other market participants that may not have the same information or insight into the facts.

Markets move in trends at least some of the time, however early identification of a trend is imperative to successfully trading in the direction of the trend whilst maximising potential profits. On the contrary, early identification of a trend reversal is a key component to exit a trade to maximise the trading potential or to minimise the potential trading loss.

 

Human nature is repeatable

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Human psychology has a large factor in technical analysis in terms of how a trader/investor act and reacts to market conditions as a result of aspirations, fears, desires and ego. Humans tend to act in the same way each time a similar situation is encountered. While some reactions may cause behaviours over time, this only applies to some market participants, in the sense that new participants are coming into the market all the time and more experienced ones are leaving the scene. New participants tend to overlook how previous markets participants have acted in the past and existing market participants often repeat the same mistakes.

 

In a simplistic sense, financial markets are often an outcome of masses of individuals observing price & interacting with each other whilst creating judgements. Humans tends to follow the crowd due to influences from peer pressures causing trader/investors to act emotionally and impulsively. Often, people will find it difficult to go against popular opinion & think independently due to the innate psychology associated with human nature. In short, the trader/investors ability to view, interpret and act on price action and trends ultimately forms a viewpoint of the likely prime movement direction.

  

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