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Technical analysis is the study of past financial market data, primarily through the use of charts, to forecast price trends and make investment decisions. In its purest form, technical analysis is concerned only with the actual price behavior of the market or instrument, based on the premise that price reflects all relevant factors before an investor becomes aware of them through other channels.
General description
Technical analysts (or technicians) try to identify non-random price patterns and trends in financial markets and attempt to exploit those patterns. While technicians use various methods and tools, the study of price charts is primary. Technicians especially search for archetypal patterns, such as the well-known head and shoulders reversal pattern, and also study such indicators as price, volume, and moving averages of the price. Many technical analysts also follow indicators of investor psychology (market sentiment).
The goal of technicians is to forecast movements in price and magnitude such that large gains from the correct predictions are enough to offset more numerous but smaller losses from incorrect predictions, leading to a positive return in the long run through proper risk control and money management.
Technical analysis is frequently contrasted with fundamental analysis, the study of economic factors that some analysts say can influence prices in financial markets. Pure technical analysis holds that prices already reflect all such influences before investors are aware of them, hence the study of price action alone. Some traders use technical or fundamental analysis exclusively, while others use both types to make trading decisions.
There are several schools of technical analysis. Adherents of different schools (for example, candlestick charting, Dow Theory, and Elliott wave theory) may ignore the other approaches, yet many traders combine elements from more than one school. Technical analysts use judgment gained from experience to decide which pattern a particular instrument reflects at a given time, and what the interpretation of that pattern should be. Technical analysts may disagree among themselves over the interpretation of a given chart.
Many academic studies say technical analysis has little predictive power, but other studies say it may produce excess returns. For example, measurable forms of technical analysis, such as non-linear prediction using neural networks, have been shown to occasionally produce statistically significant prediction results. A Federal Reserve working paper regarding support and resistance levels in short-term foreign exchange rates "offers strong evidence that the levels help to predict intraday trend interruptions," although the "predictive power" of those levels was "found to vary across the exchange rates and firms examined."
History
The principles of technical analysis derive from the observation of financial markets over hundreds of years. The oldest known branch of technical analysis is the use of candlestick techniques by Japanese traders as early as the 18th century, and now one of the main charting techniques. Munehisa Homma, a successful rice trader in 18th century Japan, wrote the first book on technical analysis. He addressed the market's bullish and bearish cycles, and said that successful trading depends on understanding market psychology.
Dow Theory inspired the use and development of modern technical analysis from the end of the 19th century, a theory based on the collected writings of Dow Jones co-founder and editor Charles Dow. Modern technical analysis considers Dow Theory its cornerstone.
Many more technical tools and theories have been developed and enhanced in recent decades, with an increasing emphasis on computer-assisted techniques.
Principles of technical analysis
Technicians believe that profits can be made by "trend following." So, if a stock price is steadily rising (trending upward), a technician will look for opportunities to buy this stock. This is why technical analysis is concerned more with where prices are moving (the direction or chart pattern), instead of why prices are moving (e.g. poor earnings, difficult business environment, poor management, or other fundamentals). Until the technician is convinced this uptrend has reversed or ended, all else equal, he will continue to own this security. To that end, technical analysts anticipate the various patterns on a price chart and take positions according to the expected pattern.
Technicians apply the tools of technical analysis to decide when the trends and patterns have begun, peaked, reversed, etc. For example, a popular technical analysis tool is a stock price's 200 day moving average. This is the average closing price of a stock over the past 200 trading days (though there are many variations on the moving average used in technical analysis). A stock that has been trending higher will have a history of an increasing daily stock price and an increasing 200 day moving average. Though the daily stock price fluctuates (up 50 cents on day 1, down 20 cents on day 2, up 10 cents on day 3, etc.), the 200 day moving average changes much more slowly and traces a smooth curve that follows the current price on a chart.
When the daily stock price violates the 200 day moving average, a technician sees strong evidence that a price trend has ended and that a new one may have begun to the opposite direction. Suppose IBM's 200 day moving average was 85 and the stock has been trending higher. If IBM closed at 84.50 a technician may sell his IBM shares, and perhaps sell short IBM because the perceived trend is reversing.
The above example also shows that technical analysis data is can be interpreted in several ways. One technical analyst might believe that IBM would need to trade below its moving average for two consecutive days before deciding the trend is over. Another might say one day is adequate. All technicians are likely to think a close below the 200 day moving average is important, but all may not agree on the best way to act. Still, in this example it is safe to assume that most technicians expect to sell IBM.
The problem in this example is: What if in the near term IBM climbs back above its 200 day moving average after the technician sells his stock? If the technical analyst follows his own rules, he may buy the stock back at a higher price than he just sold (plus commissions). This reflects some of the criticisms of technical analysis (see below). Technicians say "false signals" or "whipsaws" are an unavoidable part of using technical analysis, and that the costs of these whipsaws are outweighed by catching a stock early in a long term trend.
Technical analysis may be at odds with fundamental analysis. Fundamental analysis maintains that markets may misprice a security and, through various methods of fundamental analysis, the "correct" price can be calculated. Profits can be made by trading the mispriced security and then waiting for the market to recognize its "mistake" and reprice the security. In contrast, a technical analyst is not interested in a security's "correct" price, only in price movement.
Two well known sayings among technical analysts are, "The trend is your friend," and "Forget the fundamentals and follow the money." This raises another example of the difference between technical and fundamental analysis: Suppose a stock was trading at 124.25, and that the consensus fundamental analysis view of the stock was that it was worth 120.00. If the price rose to 125.00, then to 126.00 pence, and then to 127.00 pence, a technician may buy this stock to profit from the perceived trend. In contrast, a fundamental analyst could look to sell the stock, as it is moving away from what that analyst believes is the "correct" price.
Market action discounts everything
The purpose of technical analysis is to interpret the signals generated from market price action. Technical analysts believe that because all relevant information is already reflected by prices, it is redundant to do fundamental analysis -- including a study of micro fundamentals and global factors like economic and political news. If such factors affect a financial instrument, the price will tell.
Prices move in trends
Technical analysis relies on evidence to show that prices trend. Technicians say that markets trend up, down, or sideways (flat). This basic definition of price trends is the one put forward by Dow Theory.
An example of a security that is trending is AOL from November 2001 through August 2002. A technical analyst or trend follower recognizing this trend would look for opportunities to sell this security. AOL consistently moves downward in price. Each time the stock attempted to rise, sellers would enter the market and sell the stock; hence the "zig-zag" movement in the price. The series of "lower highs" and "lower lows" is a tell tale sign of a stock in a down trend. In other words, each time the stock edged lower, it fell below its previous relative low price. Each time the stock moved higher, it could not reach the level of its previous relative high price.
Note that the sequence of lower lows and lower highs did not begin until August. Then AOL makes a low price that doesn't pierce the relative low set earlier in the month. Later in the same month, the stock makes a relative high equal to the most recent relative high. In this a technician sees strong indications that the down trend is at least pausing and possibly ending, and would likely stop actively selling the stock at that point.
History tends to repeat itself
Technical analysts believe that investors collectively repeat the behavior of the investors that preceded them. "Everyone wants in on the next Microsoft," "If this stock ever gets to $50 again, I will buy it," "This company's technology will revolutionize its industry, therefore this stock will skyrocket," -- these are all examples of investor sentiment repeating itself. To a technician, the emotions in the market may be irrational, but they exist. Because investor behavior does repeat itself so often, technicians believe that recognizable (and predictable) price patterns will develop on a chart.
Technical analysis is not limited to charting, yet is always concerned with price trends. For example, many technicians monitor surveys of investor sentiment. These surveys gauge the attitude of market participants, specifically whether they are bearish or bullish. Technicians use these surveys to help determine whether a trend will continue or if a reversal could develop; they are most likely to anticipate a change when the surveys report extreme investor sentiment. Surveys showing overly bullish, for example, are evidence that an uptrend may reverse -- the premise being that if most investors are bullish they have already bought the market (anticipating higher prices). And because most investors are bullish and invested, one assumes that few buyers remain. This leaves more potential sellers than buyers, despite the bullish sentiment. This suggests that prices will trend down, and is an example of contrarian trading.
Though former Federal Reserve Chairman Alan Greenspan has not described himself as a technical analyst, he has said that the history of investor behavior appears to repeat itself:
"…there is one important caveat to the notion that we live in a new economy, and that is human psychology. The same enthusiasms and fears that gripped our forebears, are, in every way, visible in the generations now actively participating in the American economy. Human actions are always rooted in a forecast of the consequences of those actions... To be sure, the degree of risk aversion differs from person to person, but judging the way prices behave in today's markets compared with those of a century or more ago, one is hard pressed to find significant differences. The way we evaluate assets, and the way changes in those values affect our economy, do not appear to be coming out of a set of rules that is different from the one that governed the actions of our forebears…. As in the past, our advanced economy is primarily driven by how human psychology molds the value system that drives a competitive market economy. And that process is inextricably linked to human nature, which appears essentially immutable and, thus, anchors the future to the past."
Criticism
Lack of evidence
While technicians say their method provides excess returns over time, many academics believe that technical analysis has no predictive power. Burton Malkiel in his book "A Random Walk Down Wall Street" (8th edition, 2003) and Eugene Fama in "Efficient Capital Markets: A Review of Theory and Empirical Work," May 1970 Journal of Finance summarize many early studies, conducted from the 1950s-70s, that show that after trading costs are considered, the returns generated by many technical strategies underperform a simple buy and hold strategy.
Cheol-Ho Park and Scott H. Irwin reviewed 93 modern studies on the profitability of technical analysis and considered 59 of them to indicate positive results, and 24 negative results. "Despite the positive evidence ... it appears that most empirical studies are subject to various problems in their testing procedures, e.g., data snooping, ex post selection of trading rules or search technologies, and difficulties in estimation of risk and transaction costs." See also .
Critics of technical analysis include well known fundamental analysts. For example, Peter Lynch once commented, "Charts are great for predicting the past." Warren Buffett has said, "I realized technical analysis didn't work when I turned the charts upside down and didn't get a different answer" and "If past history was all there was to the game, the richest people would be librarians."
Inconsistencies with other market hypotheses
Efficient market hypothesis
The efficient market hypothesis (EMH) concludes that technical analysis cannot be effective. If prices quickly reflect all relevant information, no method (including technical analysis) can "beat the market". News events and new fundamental developments which influence prices occur randomly and are unknowable in advance.
Proponents of technical analysis counter that technical analysis does not completely contradict the efficient market hypothesis. Technicians agree with EMH in that they believe that all available information is reflected within a security's price; that is why technicians say a study of the price movement is necessary. Technicians also say that EMH ignores the way markets work, in that many investors base their expectations on past earnings, track record, etc. Because future stock prices can be strongly influenced by investor expectations, technicians claim it only follows that past prices influence future prices.
Technicians point to research in the field of behavioral finance, specifically that people are not the rational participants EMH makes them out to be. Market participants can and do act irrationally. Technicians have long said that irrational human behavior influences stock prices, and that this behavior leads to predictable outcomes.
EMH advocates reply that while individual market participants do not always act rationally (or have complete information), their aggregate decisions balance each other, resulting in a rational outcome (irrational optimists who buy stock and bid the price higher are countered by irrational pessimists who sell their stock, until the price reaches equilibrium). Likewise, complete information is reflected in the price because all market participants bring their own individual, but incomplete, knowledge together in the market.
Random walk hypothesis
The random walk hypothesis may be derived from the weak-form efficient markets hypothesis, which is based on the assumption that market participants take full account of any information contained in past price movements (but not necessarily other public information).
Technical analysts maintain that trends are identifiable in the market and that it's impractical to believe that prices move randomly -- they also say that, over time, prices trend in a direction until supply equals demand. Therefore, there can be no random price moves.
Regarding EMH and Random Walk, technicians say both theories ignore the realities of markets. Technician believe the market is composed neither of completely rational participants as EMH assumes (participants can be greedy, overly risky, etc. at any given time) nor are current price moves independent of past moves (technicians point to charts like AOL above). Critics respond that one can find virtually any chart pattern after the fact, but that this does not prove that such patterns are predictable. Technicians maintain that both theories would also invalidate numerous other trading strategies such as index arbitrage, statistical arbitrage and many other trading systems.
Industry
Globally, the industry is represented by The International Federation of Technical Analysts (IFTA). In the United States, the industry is represented by two national level organizations: The Market Technicians Association (MTA), the largest global professional technical society, and the Association of Professional Technical Analysts (AAPTA) American Association of Professional Technical Analysts (AAPTA). In Canada the industry is represented by the Canadian Society of Technical Analysts.
Use of technical analysis
Many traders say that trading in the direction of the trend is the most effective means to be profitable in financial or commodities markets. John W. Henry, Larry Hite, Ed Seykota, Richard Dennis, William Eckhardt, Victor Sperandeo, Michael Marcus and Paul Tudor Jones (some of the so-called Market Wizards in the popular book of the same name by Jack D. Schwager) have each amassed massive fortunes via the use of technical analysis and its concepts. George Lane, a technical analyst, coined one of the most popular phrases on Wall Street, "The trend is your friend!"
Many non-arbitrage algorithmic trading systems rely on the idea of trend-following, as do many hedge funds. A relatively recent trend, both in research and industrial practice, has been the development of increasingly sophisticated automated trading strategies. These often rely on underlying technical analysis principles (see algorithmic trading article for an overview).
Systematic trading and technical analysis
Neural networks
Since the early 90's when the first practically usable types emerged, artificial neural networks (ANNs) have rapidly grown in popularity. They are artificial intelligence adaptive software systems that have been inspired by how biological neural networks work. Their use comes in because they can learn to detect complex patterns in data. In mathematical terms, they are universal non-linear function approximators meaning that given the right data and configured correctly, they can capture and model any input-output relationships. This not only removes the need for human interpretation of charts or the series of rules for generating entry/exit signals but also provides a bridge to fundamental analysis as that type of data can be used as input.
In addition, as ANNs are essentially non-linear statistical models, their accuracy and prediction capabilities can be both mathematically and empirically tested. In various studies neural networks used for generating trading signals have significantly outperformed buy-hold strategies as well as traditional linear technical analysis methods.
While the advanced mathematical nature of such adaptive systems have kept neural networks for financial analysis mostly within academic research circles, in recent years more user friendly neural network software has made the technology more accessible to traders.
Rule-based trading
Rule-based trading is an approach to make one's trading plans by strict and clear-cut rules. Unlike some other technical methods or most fundamental analysis, it defines a set of rules that determines all trades, leaving minimal discretion.
For instance, a trader might make a set of rules stating that he will take a long position whenever the price of a particular instrument closes above its 50-day moving average, and shorting it whenever it drops below.
Charting terms and indicators
The five very common charting techniques used by everyday traders are:
- Balance days or "dojis"
- Double tops
- Channels
- Lines of resistance
- Pennants and/or flags
Other widely-known technical analysis concepts include:
- Accumulation/distribution index—based on the close within the day's range
- Average true range - averaged daily trading range
- Bollinger bands - a range of price volatility
- Breakout - when a price passes through and stays above an area of support or resistance
- Commodity Channel Index - identifies cyclical trends
- Elliott wave principle and the golden ratio to calculate successive price movements and retracements
- Hikkake Pattern - pattern for identifying reversals and continuations
- MACD - moving average convergence/divergence
- Momentum - the rate of price change
- Money Flow - the amount of stock traded on days the price went up
- Moving average - lags behind the price action
- On balance volume - the momentum of buying and selling stocks
- PAC charts - two-dimensional method for charting volume by price level
- Parabolic SAR - Wilder's trailing stop based on prices tending to stay within a parabolic curve during a strong trend
- Pivot point - derived by calculating the numerical average of a particular currency's or stock's high, low and closing prices
- Point and figure charts - charts based on price without time
- Profitability
- Relative Strength Index (RSI) - oscillator showing price strength
- Resistance - an area that brings on increased selling
- Stochastic oscillator, close position within recent trading range
- Support - an area that brings on increased buying
- Trend line - a sloping line of support or resistance
- Trix - an oscillator showing the slope of a triple-smoothed exponential moving average, developed in the 1980s by Jack Hutson
Books
- Ichimoku Charts, Nicole Elliott, Harriman House, 2007, ISBN 9781897597842
- Getting Started in Technical Analysis, Jack D. Schwager, Wiley, 1999, ISBN 0-471-29542-6
- New Concepts in Technical Trading Systems, J. Welles Wilder, Trend Research, 1978, ISBN 0-89459-027-8
- Reminiscences of a Stock Operator, Edwin Lefèvre, John Wiley & Sons Inc, 1994, ISBN 0-471-05970-6
- Street Smarts, Connors/Raschke, 1995, ISBN 0-9650461-0-9
- Technical Analysis of Futures Markets, John J. Murphy, New York Institute of Finance, 1986, ISBN 0-13-898008-X
- Technical Analysis of Stock Trends, 8th Edition (Hardcover), Robert D. Edwards, John Magee, W. H. C. Bassetti (Editor), American Management Association, 2001, ISBN 0-8144-0680-7
- Technical Analysis of the Financial Markets, John J. Murphy, New York Institute of Finance, 1999, ISBN 0-7352-0066-1
- The Profit Magic of Stock Transaction Timing, J.M. Hurst, Prentice-Hall, 1972, ISBN 0-13-726018-0
- The Free E-Book of Technical Analysis, Wallstreetcourier,
Notes
- ^ John J. Murphy, Technical Analysis of the Financial Markets (New York Institute of Finance, 1999), pages 1-5, 24-31.
- Skabar, Cloete, Networks, Financial Trading and the Efficient Markets Hypothesis
- Federal Reserve Bank of New York. Support for Resistance: Technical Analysis and Intraday Exchange Rates
- Nison, Steve (1991). Japanese Candlestick Charting Techniques. pp. 15–18.
- Hill, Arthur. "Dow Theory". Retrieved 2006-04-23.
- Alan Greenspan, "Question: Is There a New Economy?", 4 September 1998.
- R. Lawrence. Using Neural Networks to Forecast Stock Market Prices
- B.Egeli et al. Stock Market Prediction Using Artificial Neural Networks
- M. Zekić. Neural Network Applications in Stock Market Predictions - A Methodology Analysis
See also
- Algorithmic trading
- Bollinger bands
- Box spread
- Business cycle
- Financial astrology
- Forex simulator
- Grand supercycle
- Market analysis
- Market timing
- Market trends
- Profitability
- Technical analysis software
- Trader (finance)
External links
- Society of Technical Analysts of New Zealand
- International Federation of Technical Analysts
- American Association of Professional Technical Analysts
- Market Technicians Association