Definition of Technical Analysis
Technical charting analysis is a way of gathering and processing
price and volume information of a particular security by applying
mathematical equations and then plotting the resulting data onto graphs
in order to predict future price movements. Unlike the fundamental
analysis, where the economic, geo-political factors or the financial
health of a company are under scrutiny, technical analysis is only concerned with the price
and trading volume of a security. In essence, technical analysis
focuses on the effect of the previous price movements while fundamental
analysis studies the causes that could affect the market.
Charting analysis involves the manipulation of data relating to price
and trading volume that occur with respect to time. The resulting
information are then used to generate visual displays that can help
the investor uncover price patterns and trends. These patterns are more
commonly known as indicators and depending on the additional variables
used in the mathematical formulation, the indicators can be further
classified as either leading or lagging indicators. Typical
leading indicators are the williams%R, the stochastics, momentum, and
the Relative Strength Index (RSI). Typical lagging indicators are
the Moving Average Convergence/Divergence (MACD), the simple and
exponential moving averages,
and the Chaiken Oscillator. For more on indicators and how they are used in charting analysis, refer
to
section 3 of the Trend Strategist Handbook by Price Headley.
Beyond the indicators, technical analysis also consists of the
utilization of number theories such as the Fibonacci sequence
calculations, the Gann numbers and the Elliot wave theory. These number
theories are used for the most part to help forecast resistance and
support levels of a security's price.
The Cornerstones of Technical Analysis
The basis of technical analysis can be summarized by three
principles:
1. Prices fluctuate and move in patterns and trends that can be
modeled using mathematical formulas. As such, technical analysis
uses mathematical equations to uncover the patterns of market behaviors.
For many of the already identified market patterns, there is a high
probability that they will produce the expected results, and that these
patterns tend to repeat themselves on a regular basis.
2. Technical analysis is only concerned with the market action (i.e.
price movement and volume) and not the factors that drove the market to
change. That is, the price movements are a reflection of
everything that is known to the market that could have impact on the
market.
3. History tends to repeat itself. That is, although the market
is made up of numbers, it is traded by people with emotions and
predictable behaviors. Beyond the analytical aspects of trading,
there is the human psychology that has changed little over time.
Thus, the same chart patterns that were identified and categorized over
a century ago are still valid to this day; and the same patterns are
repeated over and over again throughout the history of trading.
Technical analysis relies heavily on historical trading data that are
available for a particular security. As a result, no trader can
nor should rely on the resulting chart patterns as the holy grail in
predicting the future price movement of a stock or security.
Although the analysis has its roots in mathematics, the resulting chart
patterns are not necessarily cut-and-dry, as far as interpreting the
results. Depending on the combination of indicators that a trader
decides to use, the outcome of his interpretation may be completely
opposite of another trader who analyzes the data with a different set of
indicators. Furthermore, even though one set of indicators may
provide consistently "good" results in predicting price movement of
stock A, it may not be as effective in predicting the price movement of
stock B over a specified time period or trading day. Consequently,
these stocks or groups of stocks can be aptly described as having
personalities of their own. Although the same indicators are used
in the various trading markets (i.e., the stock market, the futures
market, the Forex market, etc.), the techniques and strategies used for
technical charting analysis may differ from one market to the next.
Thus, depending on the market of interest, the reader may benefit
learning a specific trading strategy that is tailored to the particular
market. Some of the more popular trading systems are outlined
below:
There are numerous trading systems available
online that utilize different combinations of leading and
lagging indicators to help investors guide their trades. To learn more about technical charting analysis, visit these sites: