13.2.2 Overview Of Technical Analysis

Overview of Technical Analysis

Technical analysis is a method used to forecast the future price movements of a security based on historical price data. Unlike fundamental analysis, which focuses on a company’s intrinsic value, technical analysis is concerned with price action and market trends. The underlying belief of technical analysts is that all relevant information is already reflected in the price, and patterns will repeat because human psychology does not change.

Key Principles of Technical Analysis:

1. Market Action Discounts Everything: All known information is already priced into the market.
2. Price Moves in Trends: Prices are often driven by identifiable trends; a trend once established tends to persist.
3. History Tends to Repeat Itself: Price patterns are assumed to recur over time, driven by market psychology.

Tools and Techniques

Price Charts

Technical analysts use various type of price charts to observe historical data:

1. Line Charts: Connect closing prices over a specified period.
2. Bar Charts: Include opening, high, low, and closing (OHLC) prices per period.
3. Candlestick Charts: Provide a more visual sentiment analysis via ‘candles’ which show the same information as bar charts.

Indicators and Oscillators

• Moving Averages: Used to smooth price data to identify trends. Common averages include Simple Moving Average (SMA) and Exponential Moving Average (EMA).
• Relative Strength Index (RSI): Measures the speed and change of price movements to evaluate overbought or oversold conditions.
• Moving Average Convergence Divergence (MACD): Shows the relationship between two moving averages of a security’s price.

Market Sentiment Analysis

Technical analysis dives into market sentiment and investor psychology. Often markets are influenced by emotional reactions rather than rational thinking, particularly in times of uncertainty.

Mental Models Used in Technical Analysis:

• Herd Mentality: Investors following the majority’s actions, regardless of evidence or perspective.
• Overreaction: Exaggerated market responses to news events.

Program Trading and Its Effects

Program trading, including high-frequency trading (HFT), involves sophisticated algorithms executing large volumes of trades instantly. While providing liquidity, it can also lead to exaggerated price movements unattached from fundamental evaluations.

Example: Market Reactions

A historical perspective highlights how technical analysis can provide insight due to reproducible investor behavior patterns:

The Subprime Mortgage Crisis (2008-2009)

During this period, market uncertainty led to widespread irrational seller-bias.

    graph TD;
	  collapsed_market[Stock Market Collapse]
	  subprime[Subprime Mortgage Crisis]
	  sellers(Sell-off by Investors)
	  market-recover[Market Recovery Around 2013]
	  subprime --> collapsed_market
	  collapsed_market --> sellers
	  sellers -->|Late Response| market-recover

Flash Crash (May 6, 2010)

An abrupt plunge and rebound triggered by HFT activities:

    graph TD;
	  dji_fall[Base: Dow Jones Industrial Average Falls]
	  panic[Initial Investor Panic]
	  hft_trade[High-Frequency Trading Impact]
	  dji_rise[Rebound in Five Minutes]
	  dji_fall --> panic
	  panic --> hft_trade
	  hft_trade --> dji_rise

Frequently Asked Questions (FAQs)

What is technical analysis?

Technical analysis involves predicting future market movements based on past market data, analysis of price charts, and market sentiment.

How do technical analysts predict price movements?

They study historical price patterns and use tools such as moving averages, oscillators, and price charts to understand market psychology.

Why do patterns repeat in technical analysis?

Patterns tend to repeat due to consistent human psychological behavior in reacting to market events.

Key Takeaways

• Technical analysis relies on historical price movements rather than intrinsic value.
• Market sentiments and investor psychology play a crucial role in price predictions.
• Tools and indicators like moving averages and RSI are essential in analyzing trends and momentum.
• Program trading, including HFT, can significantly impact market movements.

Glossary

• Technical Analysis: The forecasting of future financial price movements based on examination of past price movements.
• Moving Average: A widely used indicator in technical analysis that helps smooth out price action by filtering out the randomness from short-term price fluctuations.
• RSI: Relative Strength Index, a measure of the speed and change of market movements.
• MACD: Moving Average Convergence Divergence, a trend-following momentum indicator.
• HFT (High-Frequency Trading): A type of algorithmic trading that involves the rapid execution of a large number of orders.

Remember: Thorough knowledge and critical application of technical analysis can help in making informed trading decisions in volatile and uncertain market environments.