Technical Analysis
Introduction:
Technical analysts, technicians or market analysts develop technical trading rules from
observations of past price movements of the stock market and individual stocks.
This approach is different from:
The Efficient Market Hypothesis: It contends that past performance has no influence on
future performance or market values.
Fundamental Analysis: It involves making investment decisions based on the examination
of the economy, an industry, and company variables that lead to an estimate of intrinsic
value for an investment, which is then compared to its prevailing market price.
Fundamental analysts use economic data that is usually separate from the stock or bond
market, technical analysts use data from the market itself, such as prices and the volume of
trading, because they contend that the market is its own best predictor.
Underlying Assumptions of Technical Analysis:
1. Prices are set by supply and demand.
2. Supply and demand are influenced by many rational and irrational factors.
3. Stock prices move in trends.
4. Trends change when supply and demand change.
The first two assumptions are universally accepted by technicians and non-technicians
alike. However, analysts have different opinions about how quickly stock prices adjust
when supply and demand change. Fundamental analysts and efficient market supporters
expect an abrupt price adjustment. Technicians expect a gradual price adjustment to reflect
gradual dissemination of information.
, Advantages of Technical Analysis:
1. Removes emotion from investing: Technicians follow consistent rules that apply
to most investments, which helps in making logical, unemotional decisions.
2. Avoids issues with accounting statements: Technical analysis relies on market
data, not financial reports.
Financial statements can be misleading or incomplete due to:
Lack of detailed breakdowns (e.g. product-wise sales or customer info),
Flexibility in accounting methods
Exclusion of non-quantifiable factors (e.g. employee loyalty, brand
reputation).
3. Doesn’t require early access to information: Unlike fundamental analysts,
technicians don’t need to get new information before others or analyze it instantly.
4. Focuses on market behavior, not reasons: Technicians just need to identify
patterns or trends, not understand the cause behind them.
5. Better market timing: Technicians usually act once a price movement starts,
increasing the chances of entering or exiting at the right time—unlike fundamental
analysts who may act too early or too late.
Challenges to Technical Analysis
Challenges to the Assumptions of Technical Analysis:
The main challenge to technical analysis is research on the efficient market hypothesis
(EMH), which shows that prices move randomly. As a result, trading strategies based on
past prices generally can’t outperform a basic buy-and-hold approach after costs and risks
are considered.
Challenges to Technical Trading Rules:
1. Past patterns may not repeat: Just because something worked before doesn’t
mean it will work again.
2. Self-fulfilling prophecy: If many traders believe a stock will rise above a certain
price and buy it, they cause the price to rise.
3. Popular rules lose effectiveness: Once a rule becomes widely known and used,
many traders try to act early. This ruins the pattern or reduces the profit, making
the rule less useful.
Introduction:
Technical analysts, technicians or market analysts develop technical trading rules from
observations of past price movements of the stock market and individual stocks.
This approach is different from:
The Efficient Market Hypothesis: It contends that past performance has no influence on
future performance or market values.
Fundamental Analysis: It involves making investment decisions based on the examination
of the economy, an industry, and company variables that lead to an estimate of intrinsic
value for an investment, which is then compared to its prevailing market price.
Fundamental analysts use economic data that is usually separate from the stock or bond
market, technical analysts use data from the market itself, such as prices and the volume of
trading, because they contend that the market is its own best predictor.
Underlying Assumptions of Technical Analysis:
1. Prices are set by supply and demand.
2. Supply and demand are influenced by many rational and irrational factors.
3. Stock prices move in trends.
4. Trends change when supply and demand change.
The first two assumptions are universally accepted by technicians and non-technicians
alike. However, analysts have different opinions about how quickly stock prices adjust
when supply and demand change. Fundamental analysts and efficient market supporters
expect an abrupt price adjustment. Technicians expect a gradual price adjustment to reflect
gradual dissemination of information.
, Advantages of Technical Analysis:
1. Removes emotion from investing: Technicians follow consistent rules that apply
to most investments, which helps in making logical, unemotional decisions.
2. Avoids issues with accounting statements: Technical analysis relies on market
data, not financial reports.
Financial statements can be misleading or incomplete due to:
Lack of detailed breakdowns (e.g. product-wise sales or customer info),
Flexibility in accounting methods
Exclusion of non-quantifiable factors (e.g. employee loyalty, brand
reputation).
3. Doesn’t require early access to information: Unlike fundamental analysts,
technicians don’t need to get new information before others or analyze it instantly.
4. Focuses on market behavior, not reasons: Technicians just need to identify
patterns or trends, not understand the cause behind them.
5. Better market timing: Technicians usually act once a price movement starts,
increasing the chances of entering or exiting at the right time—unlike fundamental
analysts who may act too early or too late.
Challenges to Technical Analysis
Challenges to the Assumptions of Technical Analysis:
The main challenge to technical analysis is research on the efficient market hypothesis
(EMH), which shows that prices move randomly. As a result, trading strategies based on
past prices generally can’t outperform a basic buy-and-hold approach after costs and risks
are considered.
Challenges to Technical Trading Rules:
1. Past patterns may not repeat: Just because something worked before doesn’t
mean it will work again.
2. Self-fulfilling prophecy: If many traders believe a stock will rise above a certain
price and buy it, they cause the price to rise.
3. Popular rules lose effectiveness: Once a rule becomes widely known and used,
many traders try to act early. This ruins the pattern or reduces the profit, making
the rule less useful.
