13.5 Technical Analysis

Technical Analysis

Tools Used in Technical Analysis

Technical analysis focuses on analyzing historical market action to determine probable future price trends. Unlike fundamental analysts, who study a broad range of data, technical analysts consider this data too vast and unwieldy to accurately pinpoint price movements. Instead, they direct their attention to the market itself, whether it pertains to commodities, equities, interest rates, or foreign exchange. They plot the past and present movements of prices, the trading volume, and statistical indicators onto charts. In the equity markets, for example, analysts track the number of advancing and declining stocks. These activities aim to identify recurrent and predictable patterns that can be used to forecast future price movements.

Market Action: Primary Sources of Information

Market action includes three primary sources of information:

1. Price
2. Volume
3. Time

Key Assumptions of Technical Analysis

Technical analysis is grounded on three key assumptions regarding these sources of information:

1. Price Discounts Everything

Technical analysts believe all known market influences are fully and automatically accounted for or discounted in market prices. They assert there is limited advantage to be gained from fundamental analysis since all necessary insights can be derived from the price action itself. By examining price action, technicians seek to measure market sentiment and expectations. The belief here is that the market itself indicates the direction and extent of its next price move.

2. Prices Move in Trends

Given that prices move in identifiable trends, which persist over relatively long periods, the primary task of a technical analyst is to identify a trend in its early stages. Analysts carry positions in that direction until evidence suggests the trend is reversing.

3. Historical Patterns Repeat

The assumption here is that historical price movements tend to repeat themselves due to the market psychology inherent in investor behavior. Technical analysts look for patterns and signals that have proven to be reliable over time.

    graph TD
	    A[Technical Analysis Assumptions]
	    A --> B[1. Price Discounts Everything]
	    A --> C[2. Prices Move in Trends]
	    A --> D[3. Historical Patterns Repeat]
	
	    C -->|Uptrend| E[Prolonged Period Ascending]
	    C -->|Downtrend| F[Prolonged Period Descending]
	
	    E --> G[Trend Identification: Buy Signal]
	    F --> H[Trend Identification: Sell Signal]
	
	    style B fill:#f9f,stroke:#000,stroke-width:2px
	    style C fill:#bbf,stroke:#000,stroke-width:2px
	    style D fill:#bff,stroke:#000,stroke-width:2px
	    style E fill:#cfc,stroke:#000,stroke-width:2px
	    style F fill:#fcc,stroke:#000,stroke-width:2px
	    style G fill:#9f9,stroke:#000,stroke-width:2px
	    style H fill:#f99,stroke:#000,stroke-width:2px

History Repeats Itself

Technical analysts hold the view that markets are reflections of investor psychology and that the behavior of investors tends to repeat itself. Investors can fluctuate between emotions such as pessimism, fear, panic, optimism, greed, and euphoria.

By comparing the current investor behavior, as reflected through market action, to historical market behavior, analysts make informed predictions. Even if history doesn’t repeat itself exactly, valuable lessons can still be learned from the past movements.

Key Takeaways

• Technical analysts focus on charts that display historical market actions including price trends, trading volumes, and statistical indicators.
• The three primary sources of information in technical analysis are price, volume, and time.
• The fundamental assumptions of technical analysis include: price discounts everything, prices move in trends, and history repeats itself.
• The ultimate goal is to use these patterns to forecast future market movements by understanding and anticipating market psychology.

Frequently Asked Questions (FAQs)

1. What is technical analysis? Technical analysis is the study of past market data, primarily price and volume, to forecast future price movements based on observed historical trends and patterns.

2. Why do technical analysts focus less on fundamental data? Technical analysts believe that all known fundamental information is already reflected in the price of securities, making the study of market price movements more informative.

3. How do technical analysts identify a trend? Analysts use charts displaying past price movements, looking for sustained patterns of ascension (uptrend) or declination (downtrend). Once identified, they follow this trend until signs of reversal appear.

4. Do technical analysis predictions always hold true? While not infallible, technical analysis provides a useful heuristic framework. Given the repetitive nature of market behavior, it increases the probability of accurately forecasting future price movements.

Glossary

• Technical Analysis: A method of evaluating securities by analyzing statistics generated by market activity, such as past prices and volume.
• Fundamental Analysis: A method of evaluating securities by attempting to measure their intrinsic value, made through examining related economic, financial, and other qualitative and quantitative factors.
• Trend: The general direction in which something tends to move; in finance, this often pertains to the movement of price.
• Trading Volume: The quantity of shares, contracts, or lots traded in a security or an entire market during a given period.

Canadian Securities Course | Volume 2

In this section

• 13.5.1 Comparing Technical Analysis To Fundamental Analysis
  Understanding the key differences and applications of technical analysis and fundamental analysis in investment strategies.
• 13.5.2 Commonly Used Tools In Technical Analysis
  Explore the commonly used tools in technical analysis, including chart analysis, quantitative analysis, sentiment indicators, and cycle analysis. Learn how these methods can help identify trends and make informed investment decisions.