• 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