An Introduction to TA
Technical analysis is the study of market action, primarily using charts, for the purpose of forecasting future price trends. Market action is defined as the changes in price and volume as time progresses.
The justification for studying market action rather than the fundamental factors that move price is that market action discounts (takes account of) all known information about a stock or financial instrument. The main factors that can affect price are fundamental, such as company earnings or the state of the economy, but also psychological. This second, and most important set of factors, is not dealt with satisfactorily by fundamental analysis. In practice, fundamental analysts may add their assessment of the psychological state of the market over their analysis. Technical analysis however provides a range of concepts and chartable indicators for us to gauge sentiment, so not leave us relying just on our ‘feel’ for it.
Both the fundamental and psychological factors are rapidly assimilated by the market; as soon as they become known the price adjusts to take them into account. On this basis only a study of market action is required, as this automatically includes consideration of both factors. At certain times, it may not be clear which fundamental factors are moving price but this should not concern a technical analyst. Often, these reasons become clearer once a significant move in price has already occurred. This is summed up by the phrase that ‘price leads the fundamentals’. Price moves first; only towards the end of a particular move are the fundamental reasons fully apparent and understood by all market participants.
Much of technical analysis involves pattern recognition on price charts. For identifiable patterns to recur, history has to repeat itself. Technical analysts maintain that history does repeat itself because human psychology tends to stay the same. Society may change and advance in some technological aspects but people remain motivated by greed, fear, hope and despair when they operate in financial markets. In particular, most people will lose at least some of their independent perspective and act as part of a crowd. The behaviour of a crowd is more predictable than any one individual and it is the crowd that will dictate market action. Therefore technical analysis combines a qualitative understanding of the psychology of the market with more quantitative analysis of price and volume on charts. Furthermore, these two strands feed back on one another; charts paint a picture of market psychology which then gives context to subsequent price chart moves.
Technical concepts can be applied to any type of price series, be it equity, currency, commodity or bond. They can be applied over the long, medium and short term. The initial stages of analysis are quick when compared with fundamental analysis. This means that a technical analyst can cover many more markets than a fundamental analyst. Given that markets affect one another, the technical analyst can form a broader picture of the market than a fundamental analyst would have time to form.
This six part series aims to outline the key concepts of technical analysis, and highlight some of the techniques that can be applied by traders to identify and manage trades. The parts of the series are as follows:
1. Introduction
2. The concept of trend
3. Support, resistance and other price patterns
4. Signals and chart patterns
5. Indicators and other tools
6. Applying TA to leveraged trading scenarios.
A glossary of some commonly used technical analysis terms are also included.
John Ritchie, MSTA
Technical Analyst
Investors Intelligence
December 2006