What is technical analysis?
In finance, technical analysis is an analysis methodology for forecasting the direction of prices on financial markets mainly using graphics and statistical methods. It is used, together with fundamental analysis, to make trading decisions.
Fundamental analysis examines the performance of business operations and profitability. Technical analysis draws on various methods, tools and techniques to analyse price trends. Using price charts, technical analysts seek to identify price patterns that repeat over time to optimise the timing of investments and divestments.
Originally, technical analysis was only applied to the stock market, but its use has gradually spread to the commodities, bond, currency and other international markets.
Origins of technical analysis
Charles Dow (1851-1902, founder of the Wall Street Journal and inventor of the Dow Jones Industrial Average ) is considered the father of Technical Analysis. At the start of the 20th century, he laid the theoretical groundwork of this discipline, establishing its basic principles, with the aim of using the behaviour of the stock market as an indicator for general economic performance.
What is now known as Dow Theory, i.e., the fundamental principles of chart analysis, began as a series of editorials that Dow published in the Wall Street Journal between 1900 and 1902.
The fundamental principles
These are, as Dow’s editorials explain, the six fundamental principles of technical analysis:
- The market discounts all available information. In other words, the price of a trade immediately reflects all known information at any time.
- Market performance can be broken down into three trends. Dow identified three types of trends (stages of price directionality): Primary trends, which last at least one year, within which there are Secondary trends, which last a few weeks and run counter to the primary trend, and “Minor” trends, which generally last less than three weeks and go in the same direction as the primary trend.
- Market trends have three phases. Dow theory distinguishes between three phases: accumulation, public participation and distribution. In an upwards trend, the first phase is accumulation: only the most far-sighted and “in-the-know” investors are actively buying because the good news about the economic cycle has not yet spread. Next comes the public participation phase: the goods news has spread throughout the market and prices start to rise (sometimes rapidly). Finally, in the distribution phase, prices now discount all good news (since the information is now in the public domain): those who bought in the first phase begin to sell and only small investors attracted by the previous, strong growth are buying, until the trend inverts. The bearish trend then begins, counter to the bullish trend, with a distribution, and it will end with an accumulation.
- Stock market averages must confirm each other. Dow studied the industrial and rail companies indices. He believed that a new peak signalled that a trend would continue only both indices were peaking (without the need for them to peak at exactly the same time).
- Volumes confirm trends. Where “volume” means the number of transactions carried out in a certain period of time. According to Dow, in an uptrend, volume should increase when prices rise and should contract when prices fall. If, on the other hand, prices rise and volumes contract, and therefore there is a divergence between these two trends, the price trend will soon invert.
- Trends exist until definitive signals prove that they have ended Trends, regardless of whether they are headed up or down, have their own momentum and will tend to continue moving in the same direction rather than invert.
The basic assumptions
Having given some historical background, let’s now explore the basic assumptions behind Dow theory and, therefore, the practice of technical analysts. These assumptions are based on a strictly empirical analysis that is easy to see in the daily performance of financial markets:
- Averages discount everything Technical analysts believe that the market price of any financial instrument is the result of the combination of all the political, economic and financial news and expectations that can theoretically affect its trend. Consequently, the “technical” study of the price already contains all the available information that could be used to develop forecasts;
- Prices move according to trends. This is the central tenet of all chart studies. Without this assumption, the study of charts is pointless. This assumption is not necessarily a given: according to certain traditional economic theories, like the random walk theory, stock market prices cannot be predicted. To sceptics, technical analysts can only offer empirical evidence;
- History repeats itself. This assumption is based on the study of human psychology: since market behaviour is dictated by human decisions and since humans tend to act similarly in similar circumstances, it follows that market performance will also tend to be similar in similar circumstances. This is the assumption that gives rise to the part of technical analysis best known to non-experts, the area that deals with the study of chart patterns (double tops and bottoms, bullish and bearish head and shoulders, just to name a few), which owes their reliability precisely to the fact that they reappear with similar characteristics in subsequent market phases.
How to identify a trend
Trends are identified by a series of highs and lows that subsequently rise in a bullish market, or fall in a bearish one, and remain so until they reverse course. The technical analyst’s primary objective is to be able to identify the directional phase of the market and recognise the potential critical levels of trend inversion or continuation. If it is impossible to identify a dominant direction in prices, it would be more correct to say that the trend is lateral rather than that there is no trend. Trends can therefore take three directions, upwards, downwards and lateral.
Recognising these three types of trends and the transition from one to another is the main purpose of technical analysis. In fact, investment strategies are mainly structured around the inversion phases. However, while in some cases it is relatively easy to recognise the type of price trend in progress, in others more sophisticated tools than simple observation must be used to determine the direction of the trend. Finding the answer to the question “What kind of trend am I in?” – which should be at the foundation of the study of each graph – it not always easy. This is why all the different areas of chart analysis were created, grouped together under one name, “technical analysis”: to find the answer for every situation, even the more complicated ones.
How technical analysis works
Technical analysis is performed by interpreting the specific keys used to predict the performance of financial markets. Specifically, these keys are charts, indicators and oscillators.
- Charts are lines that represent price trends over time, revealing patterns of repetitive behaviour;
- Indicators summarise salient information on the performance of markets and financial instruments
- Oscillators are indicators that can help identify excessive tops and bottoms or the waning of the dominant trend (phase of price directionality).
There are several different types of technical analysis charts:
- A line chart is the simplest type of charts as it plots the closing price of the underlying security each day;
- Point and figure charts are less intuitive, using a column with Xs to indicate when a stock rises and Os to show when it falls. It is the least frequently used chart.
- Candlestick charts, sometimes called Japanese candlestick charts, use a series of blocks, which makes them similar to traditional bar charts, to analyse the performance of a stock simply by entering parameters such as opening price, highs and lows.
Oscillators were developed to provide a viable alternative to the trend-following approach. They are extremely useful tools for technical analysts studying markets with lateral trends, where prices move sideways between horizontal bands, a situation where the results of trend-following instruments are less than satisfactory.
However, it should be stressed that the use of oscillators is not limited solely to lateral markets, but, if supported by proper chart analysis and once a well-defined trend has been identified, they can be a valuable tool in identifying extreme conditions due to excessive ups and downs. They also help to identify market phases characterised by a loss of momentum in the current trend, which traditional charts do not detect.
Many oscillators are similar. They are usually placed at the bottom of the charts and generally plot a course contained in a horizontal band, regardless of the trend in the analysed stock. It is important to emphasise the fact that the low and high bands of the oscillators coincide with those plotted in the chart. In general, there are three situations in which the oscillator provides analysts with potential information:
- when the value reaches the upper or lower oscillation band. This indicates that the market condition is overbought or oversold, highlighting how the price trend is too tight;
- when there is a divergence between the oscillators and the price trend is in an extreme position; this indicates a very dangerous situation;
- a movement past the middle line dividing the horizontal band in two equal parts can be a very meaningful indication of the direction of the price trend.
Some of the main indicators and oscillators used in technical analysis are:
- Bollinger bands – two bands that almost always contain price volatility
- Moving average – average prices for a given period
- Relative strength Index
The pros and cons of technical analysis
The pros of technical analysis
Being able to read price signals in a given market is a key element of any trading strategy. All financial operators must develop a method to locate the best entry and exit points in a market. To do this, they often rely on technical analysis tools.
These tools are so widely used that many believe that they have generated self-fulfilling market rules: as more and more financial operators use the same indicators to find support and resistance levels, more and more buyers and sellers will be concentrated near the same price points. So the patterns will inevitably repeat.
The cons of technical analysis
Market behaviour will always have an element of unpredictability, as a result of the multiplicity of choices made by operators. Any form of analysis, be it technical or fundamental, can lead to incorrect predictions about the price trends.