Technical analysis, what is it?
Rob Lee Senior Analyst of the AiMS Forex Trading and Training club describes technical analysis, its rationale, theory and mind-set.
To study technical analysis we need to define what it is and separate it from other methods used, such as fundamental analysis, to determine market movements and direction.
Technical analysis is the study of market action using primary charts to forecast the future price of a given market or security. Market action is a term that includes the three principal sources of information used by a technician:
- Price
- Volume
- Open interest
Price action is a term that is not to be confused with market action, price action refers solely to the open, high, low and close (OHLC) prices of a given period of time for a given market or security.
As technicians our philosophy states that:
- Market action discounts everything
- Price moves in trends
- History is repetitive
Market action discounts everything
Market Action, the foundation of our study of the markets, which is primary to understanding our analysis, is that everything that can affect price fundamentally, political, psychological, geographical, acts of god or otherwise is built into the price of that market.
A technical analyst is stating that by studying the market action of a security they are actually studying the shift in supply and demand, if demand exceeds supply the price will raise and conversely if supply exceeds demand the price will fall, the basis for all economic and fundamental analytical work.
A technician reverses the conclusion by stating that if market action is rising then the fundamentals must be that demand is exceeding supply and that if the market action is falling then that fundamentally the supply is out striping demand and must be bearish.
A technical analyst then can state that all that needs to be studied is Market action, to forecast the future direction of a market. A technician is not overly concerned with the “why” a price rises or falls, but more “when” a price turns at a critical point often when no one really knows why in the early stages of a price trend.
The logic is that the market discounts everything, everything that affects price is already reflected in the market from grass roots up. By studying the market action the wealth of knowledge in the Market is telling the technician which way is the likely future direction. There are reasons why the market moves up or down, but as technicians do not feel that knowing the reasons are necessary to forecast direction, not why but when.
Price moves in trends
The concept a technician understands is that price moves in trends. A technical analyst has to believe price moves in trends to make his predictions. This theory is key to identifying the crucial stages of a price trend change, the optimal point at which to trade in the direction of a trend. An out come of this is bastardised from Newton’s first law of motion, a trend is more likely to continue then reverse.
Simplified, a trend will continue until it reverses, therefore a technician will ride a trend until it shows signs of reversal, the basis of our work as technical analysts / traders.
History is repetitive
Technical analysis is the study of market action, which is effectively the study of human psychology. Patterns emerge in a chart for that very reason as human psychology, which tends not to change, repeats its self. The study of the past will give us insights of the future.
Technical vs. fundamental
Fundamentalists concentrate on the laws of supply and demand, which moves price up or down. All the relevent factors are dialled into their analysis to produce an intrinsic value, what it is worth. If the value is under priced then it must be bought, likewise if intrinsic value is over price, or overbought, then a selling order would be correct.
Both technical and fundamental analysis is attempting to answer the same question, the direction of price albeit with different tools. Fundamental analysis looks at the cause while the technician looks at the effect. A technician believes the effect is all that is required to reach a conclusion, whilst the fundamentalist always has to know why.
In real terms there is a lot of overlap, fundamentalists for example use basic technical analysis and the technician will have at least a rudimentary awareness of the fundamentals, economic news for example. A problem arises, often at the beginning of a critical move in the markets the fundamentals do not correlate with the actual market conditions. This presents a conflict as technical analysts contradict fundamental analysis.
The only conclusion we can reach is that the market trend tends to lead the fundamentals, in other words market action is a lead indicator for the known fundamentals. Unknown fundamentals are working of which the market has yet to discount from price, often major moves in the market begin with little or no change in the known fundamentals and the move is well underway before the fundamentals come into the conscious knowledge of the market masses.
As a technician we become at ease in positions where conventional wisdom disagrees, we just don’t need or are unwilling to wait for fundamental confirmation.
Timing
Leverage demands excellent timing, futures markets for example with high leverage requires accurate timing of execution as we take on positions with low margin requirements. A small move in price can realise profits or more importantly force a trader out of the market and produce a loss. Unlike stocks where we can buy and hold, we can be, as a futures trader, the correct side of the market and still lose as timing becomes important.
Technical analysis is the only discipline we can employ to accurately deploy entry and exit points. Although we can use fundamental or technical to forecast in the primary stage, technical is the only choice we have to execute efficiently in the futures markets.
Finally, a technician can adapt to almost any market they wish, very quickly allowing the bigger picture to been seen with inter-market analysis across various key factors, from Stocks buy and hold to fast moving futures. This a key strength of technical analytical practices, which is not matched by a fundamentalist who requires large amounts of data in their specialist field to forecast, a technician simply pulls up a chart and begins work without specialist knowledge in the given sector.