Technical analysis
In finance, technical analysis is an analysis methodology for analysing and forecasting the direction of prices through the study of past market data, primarily price and volume. As a type of active management, it stands in contradiction to much of modern portfolio theory. The efficacy of technical analysis is disputed by the efficient-market hypothesis, which states that stock market prices are essentially unpredictable, and research on whether technical analysis offers any benefit has produced mixed results. It is distinguished from fundamental analysis, which considers a company's financial statements, health, and the overall state of the market and economy.
History
The principles of technical analysis are derived from hundreds of years of financial market data. Some aspects of technical analysis began to appear in Amsterdam-based merchant Joseph de la Vega's accounts of the Dutch financial markets in the 17th century. In Asia, technical analysis is said to be a method developed by Homma Munehisa during the early 18th century which evolved into the use of candlestick techniques, and is today a technical analysis charting tool.Journalist Charles Dow compiled and closely analyzed American stock market data, and published some of his conclusions in editorials for The Wall Street Journal. He believed patterns and business cycles could possibly be found in this data, a concept later known as "Dow theory". However, Dow himself never advocated using his ideas as a stock trading strategy.
In the 1920s and 1930s, Richard W. Schabacker published several books which continued the work of Charles Dow and William Peter Hamilton in their books Stock Market Theory and Practice and Technical Market Analysis. In 1948, Robert D. Edwards and John Magee published Technical Analysis of Stock Trends which is widely considered to be one of the seminal works of the discipline. It is exclusively concerned with trend analysis and chart patterns and remains in use to the present. Early technical analysis was almost exclusively the analysis of charts because the processing power of computers was not available for the modern degree of statistical analysis. Charles Dow reportedly originated a form of point and figure chart analysis. With the emergence of behavioral finance as a separate discipline in economics, Paul V. Azzopardi combined technical analysis with behavioral finance and coined the term "Behavioral Technical Analysis".
Other pioneers of analysis techniques include Ralph Nelson Elliott, William Delbert Gann, and Richard Wyckoff who developed their respective techniques in the early 20th century.
General description
Fundamental analysts examine earnings, dividends, assets, quality, ratios, new products, research and the like. Technicians employ many methods, tools and techniques as well, one of which is the use of charts. Using charts, technical analysts seek to identify price patterns and market trends in financial markets and attempt to exploit those patterns.Technicians using charts search for archetypal price chart patterns, such as the well-known head and shoulders or double top/bottom reversal patterns, study technical indicators, moving averages and look for forms such as lines of support, resistance, channels and more obscure formations such as flags, pennants, balance days and cup and handle patterns.
Technical analysts also widely use market indicators of many sorts, some of which are mathematical transformations of price, often including up and down volume, advance/decline data and other inputs. These indicators are used to help assess whether an asset is trending, and if it is, the probability of its direction and of continuation. Technicians also look for relationships between price/volume indices and market indicators. Examples include the moving average, relative strength index and MACD. Other avenues of study include correlations between changes in Options and put/call ratios with price. Also important are sentiment indicators such as Put/Call ratios, bull/bear ratios, short interest, Implied Volatility, etc.
There are many techniques in technical analysis. Adherents of different techniques may ignore the other approaches, yet many traders combine elements from more than one technique. Some technical analysts use subjective judgment to decide which pattern a particular instrument reflects at a given time and what the interpretation of that pattern should be. Others employ a strictly mechanical or systematic approach to pattern identification and interpretation.
Comparison with fundamental analysis
Contrasting with technical analysis is fundamental analysis: the study of economicand other underlying factors that influence the way investors price financial markets. This may include regular corporate metrics like a company's recent EBITDA figures, the estimated impact of recent staffing changes to the board of directors, geopolitical considerations, and even scientific factors like the estimated future effects of global warming. Pure forms of technical analysis can hold that prices already reflect all the underlying fundamental factors. Uncovering future trends is what technical indicators are designed to do, although neither technical nor fundamental indicators are perfect. Some traders use technical or fundamental analysis exclusively, while others use both types to make trading decisions.
Comparison with quantitative analysis
The contrast against quantitative analysis is less clear cut than the distinction with fundamental analysis. Some sources treat technical and quantitative analysis as more or less synonymous, while others draw a sharp distinction. For example, quantitative analysis expert Paul Wilmott suggests technical analysis is little more than 'charting', and that technical analysis rarely has any predictive power.Principles
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 trends
Technical analysts believe that prices trend directionally, i.e., up, down, or sideways 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. 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 who 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 price patterns will develop on a chart. Recognition of these patterns can allow the technician to select trades that have a higher probability of success.Technical analysis is not limited to charting, but it always considers price trends. For example, many technicians monitor surveys of investor sentiment. These surveys gauge the market sentiment of 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. 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. 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 investing.
Industry
The industry is globally represented by the International Federation of Technical Analysts, which is a federation of regional and national organizations. In the United States, the industry is represented by both the CMT Association and the American Association of Professional Technical Analysts. The United States is also represented by the Technical Security Analysts Association of San Francisco. In the United Kingdom, the industry is represented by the Society of Technical Analysts. The STA was a founding member of IFTA, has recently celebrated its 50th anniversary and certifies analysts with the Diploma in Technical Analysis. In Canada the industry is represented by the Canadian Society of Technical Analysts. In Australia, the industry is represented by the Australian Technical Analysts Association, and the Australian Professional Technical Analysts Inc.Professional technical analysis societies have worked on creating a body of knowledge that describes the field of Technical Analysis. A body of knowledge is central to the field as a way of defining how and why technical analysis may work. It can then be used by academia, as well as regulatory bodies, in developing proper research and standards for the field. The CMT Association has published a body of knowledge, which is the structure for the Chartered Market Technician exam.