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Charting or technical analysis is the use of numerical series generated by market activity, such as price, volume traded, and open interest 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; because of this lack of fundamental analysis, technical analysis is controversial and derided by critics as being akin to looking into a crystal ball.
The biggest advantage of technical analysis happens when combined with fundamental analysis. Start with selecting timely industries and then securities should be first short-listed using fundamental basis. Then technical analysis should be applied to the shortlist. Securities prices may fluctuate every second based on demand and supply and hence buying at a good price may be important. Technical analysis may help in getting a good price to buy or sell.
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 securities.
Technical analysts, or chartists, believe that by analysing securities price histories, they can discern sufficient information about the thinking of buyers and sellers to anticipate future events. The assumption is that there is useful information to be gleaned, hidden within price histories; that technical analysis is a way of analysing the past actions of the people participating 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 investment banks, however, employ both technical analysts and financial mathematicians.
Critics say that technical analysis is no better than mystic divination cloaked in numbers and mumbo jumbo. It has been noted that technical analysis entirely failed to predict the bursting of the dot com bubble, and by its very nature could never have predicted it. Many of the worst offenders predicting future stock price growth at the peak of that bubble were technical analysts. Critics also note that there are no known billionaire technical analysts, presumably because in the long term the techniques of technical analysis do not work.
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 analyses) 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:
- Arms Index (TRIN) -
- Ascending bottom -
- Bollinger bands - a range of price volatility based on the standand deviation on an average of the closing price.
- Box-brakeout - when prices pass through, and stay beyond horizontal support and resistance areas resembling a box.
- Breakout - when prices pass through, and stay through an area of support or resistance.
- Broadening foundation -
- Commodity Channel Indicator -
- Gann lines and Gann angles -
- Momentum - ratio of a short term moving average to a long term moving average or price.
- Head and shoulders - top, higher top, lower top.
- Inverse head and shoulders - bottom, lower bottom, higher bottom.
- Lanes Stochastics - indicates entry signals based on reactions of professional traders on the close.
- MACD - Moving Average Convergence/Divergence
- Money flow -
- Moving average - the average of price, volume or open interest for an arbitrary number of periods.
- Parabolic SAR - Wilder's trailing stop based on prices tending to stay within a parabolic curve during a strong trend.
- Point and figure charts - charts based on price without time.
- Relative strength index - Wilders (RSI) measures the relative gains over relative losses over time.
- Stop loss - executes a trade based on price action.
- Trend line - a sloping line of support or resistance.
- Trend line penetration - a trend line penetration occurs when prices break through a sloping line of support or resistance leading to a breakout.
- Triangle - converging and diverging areas of support and resistance areas resembling a Triangle.
- Triple top - top, top, top
- Relative strength - ratio of the % price change of a stock to the % price change of a broader index
- Resistance - an area that brings on increased selling.
- Support - an area that brings on increased buying.
Interpretation
Chart patterns reflect human actions as they effect supply and demand. Oscillators smooth these patterns, in an attempt to filter out the noise.
Trendlines, support, resistance, box breakouts etc. can be drawn on oscillators as well as price.
There are 4 common methods to interpret indicators:
- 1. Crossovers uses the relationships between short and long term moving averages.
- 2. Divergence/Convergence patterns formed by the relationship between indicators and closing prices.
- 3. Overbought/oversold - When the indicator raises rapidly in a congestion area it may be a signal the security will soon return to normal levels.
- 4. Pop When the indicator rises rapidly and continues to trend, it may be a signal the securities will be seeking new extremes.
When you run the Oscillator over the history of the security you will be trading, you can see how it behaves before the pattern that you like to trade developes.
Books
- Technical Analysis of Futures Markets, John J. Murphy, New York Institute of Finance, 1986, ISBN 0-13-898008-X
- The Profit Magic of Stock Transaction Timing, J.M. Hurst, Prentice-Hall, 1972, ISBN 0137260180
- New Concepts in Technical Trading Systems, J. Welles Wilder, Trend Research, 1978, ISBN 0894590278
- Reminiscences of a Stock Operator, Edwin Lefèvre, John Wiley & Sons Inc, 1994, ISBN 0471059706
- Reminiscences of a stock operator (http://www.nqoos.com/Articles_and_Reprints/jesse_livermore.pdf/)
Glossary
Commodity Futures Trading Commission Glossary (http://www.cftc.gov/opa/glossary/opaglossary_a.htm/)
National Futures Association Glossary (http://www.nfa.futures.org/basicnet/Glossary.aspx/)
See also
Finding related topics
External links
Technical analysis software
Useful URLs
Articles
Indicators
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