Technical analysis is a popular technique used by investors in order to predict future prices of financial instruments (mainly shares and futures). It focuses on studying historical data connected with financial instruments (price, volume, and in case of futures also open interest) and on analysing charts, in order to find recurrent patterns useful in forecasting future market movements.
Principles of technical analysis
- Market discounts everything - Technical analysis presumes, that all factors, which can affect price of financial instrument (economic information, political situation etc.) are actually reflected by current price of analysed instrument. According to technical analysis price can rise of fall, before important data will be revealed on the market. Price in this case is treated as equilibrium between demand and supply, and reflects bullish or bearish psychology of the marketplace.
- Prices move in trends - Existence of trends is basic concept for technical analysis. Charts are used in order to determine, whether market is in up-trend, down-trend or moves sideways. What is very important for technical analysis, it assumes, that current market trend is more likely to continue than to reverse.
- History repeats itself - By analysing patterns appearing on historical charts, technical analysis examines also psychology of the market, which is based on human psychology, and thus does not change easily. All market movement happened in the past and will happen in the future.
Most popular techniques of technical analysis
- Dow Theory. This theory tries to identify long-term trends in stock market prices. It uses two indicators: the Dow Jones Industrial Average and the Dow Jones Transportation Average. According to this theory we can identify primary trends, secondary (intermediate) trends and tertiary (minor) trends. Dow Theory is used currently mainly in its variation called Elliot Waves Theory.
- Patterns. While analysing charts, technical analysts use many reversal or continuation patterns appearing on charts in order to determine when they should enter or leave the market. They also often use resistance and support levels.
- Technical Indicators: Moving Averages, Oscillators (MACD, ROC, RSI etc.).
Criticism of technical analysis
Many critics claims, that it is very difficult to recognize patterns as they emerge. Often, technical analysts see different patterns while analysing the same charts. It is easier after particular shapes appear on the charts, but then it is difficult to decide whether market moved because of the technical reasons or technical analyst is trying to prove his findings, by applying one of the various pattern to the chart.
- Murphy J., Technical analysis of the financial markets, New York Institute of Finance, 1999, page 1-2
- Bodie, Kane, Marcus, Investments, McGraw-Hill Primis, 2003, page 343-348
- Murphy, J. J. (1991). Intermarket Technical Analysis. New York.
Author: Mateusz Bąk