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Technical analysis

 

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Charting or technical analysis is the use of numerical series generated by market activity, such as price and volume, to predict future trends in that market. The techniques can be applied to any market with a comprehensive price history. Technical analysis does not try to analyze the financial data of a company such as cashflow, dividends and projection of future dividends. That type of analysis is called fundamental analysis.

While technical analysis is widely used (if only as one input among many) by both professional and amateur traders as a means of predicting future market moves, it is generally not used by economists in any academic sense.

Technical analysis implicitly rejects the efficiency of the market as understood in the efficient market hypothesis (EMH). (That is, using technical analysis on a particular market implicitly assumes that that market is not efficient, as defined by EMH.) The efficient markets theories basically argue that existing prices reflect all available information, and that future price movements will follow a path that will approximate to a random walk (Brownian motion) as they adjust to new information as it emerges. The theories further assume that all participants in the stock market have equal and instantaneous access to all information that might affect stocks. Technical analysts or chartists believe that by analysing stock price histories they can discern sufficient information about the thinking of buyers and sellers to anticipate future events. That is, they assume that there is useful information to be gleaned, i.e. hidden within, price histories; that it is a way of analyzing the past actions of people in a particular market as reflected by their actual transactions. As the assumption of an efficient market is central to almost all option pricing theory, financial mathematicians working in the area of derivatives generally reject technical analysis as unscientific. All large banks, however, employ both technical analysts and financial mathematicians.

Techniques of Technical Analysts

The traditional chartists developed familiarity with chart patterns that seemed to recur repeatedly and gave some of them names e.g. "head and shoulders" or "flag" or "triangle". They believed that they could infer probabilities of price action from studying the patterns. More recent technical analysts use a wide variety of techniques but, at their best, their methods approximate more closely to a statistical analysis of price action. For example J.M.Hurst (see below) used sophisticated techniques (fourier analysis) to search for meaningful signals amongst the apparent random noise of stock price movements. The most sophisticated technical analysis software allows the user to design indicators and to optimise them by testing their profitability (assuming trading rules and transactions costs) using historic data; trading stratagems can be designed that utilise one or more such indicators.

Charting Terms

Some of the techniques used and patterns found include:

  • Support level - a level below which the price will not likely fall.
  • Resistence level - a level above which the price will not likely rise.
  • Breakout - when a stock rises above its resistence level or below it's support level.
  • Trend line - a regression line that predicts future prices based on past prices.
  • Trend line penetration - when a price crosses Bollinger bands or some other measure of the range of standard deviation of the trend line.
  • Moving Averages - the average price of a stock calculated and recalculated for a specific number of days. Several types : simple moving average; weighted moving average; exponential moving average.
  • Momentum - ratio of a short term moving average to a long term moving average
  • Commodity Channel Indicator -
  • Relative strength - ratio of the % price change of a stock to the % price change of a broader index
  • Bollinger bands - a range of price volitility based on the standand deviation on a moving average or trend line
  • Moving average (volume) - the moving average of the daily volume (rather than price) of trades.
  • Gann lines and Gann angles -
  • Triangle -
  • Ascending bottom -
  • Broadening foundation -
  • Head and shoulders -
  • Inverse head and shoulders -
  • Triple top -
  • Arms Index (TRIN) -
  • Money flow -
  • Point and figure charts -

Further reading

  • Technical Analysis of Futures Markets, John J. Murphy, New York Institute of Finance, 1986
  • The Profit Magic of Stock Transaction Timing, J.M. Hurst, Prentice-Hall, 1970.
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