WHAT IS TECHNICAL ANALYSIS?
Technical analysis is a method of forecasting the direction of financial market prices through the evaluation of historic price and, where available, volume data.
A basic premise of the technical approach is that market action discounts everything: all that is known, or can be known, is ‘in the price’. Technical analysis is therefore not concerned with the underlying value of a security, but with the effects on the price of that security produced by the activities of market participants.
A wide range of techniques may be applied to this assessment of price action, including the study of repetitive patterns on charts, mathematical calculations to determine the speed and momentum of a move, and statistical tools to identify extreme conditions.
Behavioural Finance and Technical Analysis
Behavioural finance studies the effect of social, cognitive, and emotional factors on people’s economic decisions. It helps us better understand investors’ behaviour and shines a light on why and how markets behave the way they do. By understanding human behaviour and the psychology of the market, you can start improving your own actions as a technical analyst, and improve the quality of your output.
The STA runs a comprehensive education programme, gives monthly lectures (also available via video links), publishes its journal three times a year and offers its members access to an extensive library. All the educational courses and examinations are accredited by IFTA, the International Federation of Technical Analysts.
THE ROOTS OF TECHNICAL ANALYSIS
It is possible that technical analysis is the oldest form of financial analysis in the world. Several centuries ago in the corn markets of England and the rice markets of Japan, traders developed a method of recording transactions that would enable them to see at a glance how much people had been paying for the product. With the help of that information they were able to assess where supply and demand were in balance and thus see better what price they should agree for their future transactions. The form that this monitoring took was a series of markings on the page at different levels to represent prices as they rose and fell. The result was something very close to a modern “Point & Figure” chart.
In contrast fundamental analysis attempts to estimate the value of a currency, a share or an entire equity or bond market based on profitability, management or economic strength, and future prospects. This assumes that value is the sole determinant of price, but in fact price and perceived value are rarely in equilibrium. Prices are set by supply and demand, and they represent all that is known, feared, and hoped for by the market as a whole and its individual participants. So fundamental analysis focuses on value, but technical analysis concerns itself with price, in conjunction with volume of transactions and individual/group psychology. Part of this discipline involves the charting of historic prices, part is concerned with the statistical analysis of price and volume time series and part with the examination of the psychological state of a market in the continuous battle between fear and greed.
STUDYING THE CHARTS
Analysing price charts includes identifying short-, medium- and long-term trends, pinpointing areas where consolidation shows that supply and demand have been evenly balanced in the past and calculating price targets. In addition the discipline uses oscillating indicators to measure overbought and oversold conditions, the pace and direction of momentum and the relative performance of one item against another or against the market. These indicators help to show the ‘heat’ and speed of a market.
Technical analysis is therefore critical in deciding when it is desirable to buy or sell items, even if they may have been identified as attractive or dangerous in terms of fundamental value.
One of the many attractions of technical analysis is that its methodology can be applied almost identically in any market anywhere. The same techniques can be applied to currencies, commodities, bonds, interest rates and equities. They work as well in Japan as in Europe, in developed or developing markets. Data availability and reliability are the only obstacles to a universal application of methods and techniques.
TECHNICAL ANALYST’S TOOLBOX
Bar charts, Candlestick charts or Point & Figure charts are part of any respected technical analyst’s tool box, together with Fibonacci retracements and extensions.
A bar chart shows a sequence of vertical bars. Each bar joins the traded low to the traded high for a particular hour, day, week, month (or other period) to show the full trading range for the chosen time period. The close for the period in question is shown by a small horizontal bar extending out to the right. The opening level, if required, is normally shown as a small horizontal bar extending out to the left. Bar charts can thus provide a significant amount of information in different time frames, and are widely used for both trading and longer term investment purposes.
Candlestick charts use the same data as bar charts, but display it differently, and the use of the opening trade is not optional – it is always incorporated, as the candlestick has a wide part, called the ‘real body’, which displays the range between the chosen period’s open and close. Vertical lines (the ‘shadows’) either end show the actual high and low trades – these tend to look like the wicks of a candle. But it is the ‘real body’ that can have important forecasting implications. A close higher than the open will be represented by a ‘clear’ or white (bullish) candle, the reverse will produce a ‘filled’ or black (bearish) candle. Different colour schemes may be seen: green for bullish and red for bearish have become popular in recent years. This instant display of a bullish or bearish period makes candles very useful for traders needing to make quick decisions.
Point & Figure Charts
A Point & Figure chart shows columns of Xs, denoting rising prices, and Os, denoting falling prices. Each of these ‘boxes’ represents a pre-determined price move that must occur to justify the entry of a new X or O: only a certain move in prices prompts a chart update and the passing of time is not a factor in these charts. Prices are further filtered to start a new column: in the most commonly used 3-box reversal chart, for instance, a 3-box minimum move is required to give rise to a new column, representing a move in the opposite direction. Point & Figure charts are particularly appreciated by investors requiring unambiguous entry and exit points.
Fibonacci numbers, retracements and extensions
The 1,1,2,3,5,8,13,21,34… number sequence, constructed by adding the first two numbers to make the third, takes its name from an Italian mathematician known as ‘Fibonacci’, who discussed it some 800 years ago in his book Liber Abaci. The ratio of any number in the sequence to the next lower is approximately 1.618 (phi, the famous golden ratio); the ratio of any number to the next higher approaches the inverse, 0.618. Given the omnipresent nature of the golden ratio, the extension is made to the character of price moves. Percentages such as 38.2% and 61.8%, derived from phi or its inverse, are used to calculate potential retracements of a price advance or decline, and to pinpoint possible next price targets. These techniques, usually known as Fibonacci retracements and Fibonacci extensions (also called projections), are used both with and without the additional structures of the Elliott Wave Principle. Technicians also utilise the actual Fibonacci numbers, both in time cycle analysis and in the construction of moving averages.
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