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Technical Analysisc
In finance, technical analysis is a security analysis discipline for forecasting the direction of prices through
the study of past market data, primarily price and volume. Behavioral economics and quantitative
analysis incorporate substantial aspects of technical analysis, which being an aspect ofactive
management stands in contradiction to much of modern portfolio theory. According to the weak-
form efficient-market hypothesis, such forecasting methods are valueless, since prices follow a random
walk or are otherwise essentially unpredictable.

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The principles of technical analysis derive from the observation of financial markets over hundreds of
years.] The oldest known hints of technical analysis appear in Joseph de la Vega's accounts of the Dutch
markets in the 17th century. In Asia, the oldest example of technical analysis is thought to be a method
developed by Homma Munehisa during early 18th century which evolved into the use of candlestick
techniques, and is today a main charting tool. In the 1920s and 1930s Richard W. Schabacker published
several books which continued the work of Dow and William Peter Hamilton in his booksv
 


   and 
 . At the end of his life he was joined by his brother in
law, Robert D. Edwards who finished his last book. In 1948 Edwards and John Magee
published 

v
   which is widely considered to be one of the seminal works
of the discipline. It is exclusively concerned with trend analysis and chart patterns and remains in use to
the present. It is now in its 9th edition. As is obvious, early technical analysis was almost exclusively the
analysis of charts, because the processing power of computers was not available for statistical analysis.
Charles Dow reportedly originated a form of chart analysis used by technicians²point and figure
analysis.

Dow Theory is based on the collected writings of Dow Jones co-founder and editor Charles Dow, and
inspired the use and development of modern technical analysis from the end of the 19th century. Other
pioneers of analysis techniques include Ralph Nelson Elliott, William Delbert Gann and Richard
Wyckoffwho developed their respective techniques in the early 20th century.

Many more technical tools and theories have been developed and enhanced in recent decades, with an
increasing emphasis on computer-assisted techniques using technical analysis software.
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While fundamental analysts examine earnings, dividends, new products, research and the like, technical
analysts examine what investors fear or think about those developments and whether or not investors
have the wherewithal to back up their opinions; these two concepts are called psych (psychology) and
supply/demand. Technicians employ many techniques, one of which is the use of charts. Using charts,
technical analysts seek to identify price patterns and market trends in financial markets and attempt to
exploit those patterns. Technicians use various methods and tools, the study of price charts is but one.

Technicians using charts search for archetypal price chart patterns, such as the well-known head and
shoulders or double top/bottom reversal patterns, study technical indicators, moving averages, and look
for forms such as lines of support, resistance, channels, and more obscure formations such
as flags, pennants, balance days and cup and handle patterns.

Technical analysts also widely use market indicators of many sorts, some of which are mathematical
transformations of price, often including up and down volume, advance/decline data and other inputs.
These indicators are used to help assess whether an asset is trending, and if it is, the probability of its
direction and of continuation. Technicians also look for relationships between price/volume indices and
market indicators. Examples include the relative strength index, and MACD. Other avenues of study
include correlations between changes in options (implied volatility) and put/call ratios with price. Also
important are sentiment indicators such as Put/Call ratios, bull/bear ratios, short interest, Implied Volatility,
etc.

There are many techniques in technical analysis. Adherents of different techniques (for
example, candlestick charting, Dow Theory, and Elliott wave theory) may ignore the other approaches,
yet many traders combine elements from more than one technique. Some technical analysts use
subjective judgment to decide which pattern(s) a particular instrument reflects at a given time and what
the interpretation of that pattern should be. Others employ a strictly mechanical or systematic approach to
pattern identification and interpretation.

Technical analysis is frequently contrasted with   , the study of economic factors that
influence the way investors price financial markets. Technical analysis holds that prices already reflect all
such trends before investors are aware of them. Uncovering those trends is what technical indicators are
designed to do, imperfect as they may be. Fundamental indicators are subject to the same limitations,
naturally. Some traders use technical or fundamental analysis exclusively, while others use both types to
make trading decisions, which, conceivably, is the most rational approach.
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Technical analysis employs models and trading rules based on price and volume transformations, such
as the relative strength index, moving averages, regressions, inter-market and intra-market price
correlations, business cycles, stock market cycles or, classically, through recognition of chart patterns.

Technical analysis stands in contrast to the fundamental analysis approach to security and stock analysis.
Technical analysis analyzes price, volume and other market information, whereas fundamental analysis
looks at the actual facts of the company, market, currency or commodity. Most large brokerage, trading
group, or financial institutions will typically have both a technical analysis and fundamental analysis team.

Technical analysis is widely used among traders and financial professionals and is very often used by
active day traders, market makers and pit traders. In the 1960s and 1970s it was widely dismissed by
academics. In a recent review, Irwin and Park reported that 56 of 95 modern studies found that it
produces positive results but noted that many of the positive results were rendered dubious by issues
such as data snooping, so that the evidence in support of technical analysis was inconclusive; it is still
considered by many academics to bepseudoscience. Academics such as Eugene Fama say the evidence
for technical analysis is sparse and is inconsistent with the O
 of the efficient-market hypothesis.
Users hold that even if technical analysis cannot predict the future, it helps to identify trading
opportunities.

In the foreign exchange markets, its use may be more widespread than fundamental analysis. This does
not mean technical analysis is more applicable to foreign markets, but that technical analysis is more
recognized there as to its efficacy there than elsewhere. While some isolated studies have indicated that
technical trading rules might lead to consistent returns in the period prior to 1987, most academic work
has focused on the nature of the anomalous position of the foreign exchange market. It is speculated that
this anomaly is due to central bank intervention, which obviously technical analysis is not designed to
predict. Recent research suggests that combining various trading signals into a Combined Signal
Approach may be able to increase profitability and reduce dependence on any single rule.

Principlesc
Technicians say that a market's price reflects all relevant information, so their analysis looks at the history
of a security's trading pattern rather than external drivers such as economic, fundamental and news
events. Price action also tends to repeat itself because investors collectively tend toward patterned
behavior ± hence technicians' focus on identifiable trends and conditions.
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Based on the premise that all relevant information is already reflected by prices, technical analysts
believe it is important to understand what investors think of that information, known and perceived;
studies such as by Cutler, Poterba, and Summers titled "What Moves Stock Prices?" do not cover this
aspect of investing.


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Technical analysts believe that prices trend directionally, i.e., up, down, or sideways (flat) or some
combination. The basic definition of a price trend was originally put forward by Dow Theory.

An example of a security that had an apparent trend is AOL from November 2001 through August 2002. A
technical analyst or trend follower recognizing this trend would look for opportunities to sell this security.
AOL consistently moves downward in price. Each time the stock rose, sellers would enter the market and
sell the stock; hence the "zig-zag" movement in the price. The series of "lower highs" and "lower lows" is
a tell tale sign of a stock in a down trend. In other words, each time the stock moved lower, it fell below its
previous relative low price. Each time the stock moved higher, it could not reach the level of its previous
relative high price.

Note that the sequence of lower lows and lower highs did not begin until August. Then AOL makes a low
price that does not pierce the relative low set earlier in the month. Later in the same month, the stock
makes a relative high equal to the most recent relative high. In this a technician sees strong indications
that the down trend is at least pausing and possibly ending, and would likely stop actively selling the stock
at that point.

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Technical analysts believe that investors collectively repeat the behavior of the investors that preceded
them. To a technician, the emotions in the market may be irrational, but they exist. Because investor
behavior repeats itself so often, technicians believe that recognizable (and predictable) price patterns will
develop on a chart.

Technical analysis is not limited to charting, but it always considers price trends. For example, many
technicians monitor surveys of investor sentiment. These surveys gauge the attitude of market
participants, specifically whether they are bearish or bullish. Technicians use these surveys to help
determine whether a trend will continue or if a reversal could develop; they are most likely to anticipate a
change when the surveys report extreme investor sentiment Surveys that show overwhelming
bullishness, for example, are evidence that an uptrend may reverse; the premise being that if most
investors are bullish they have already bought the market (anticipating higher prices). And because most
investors  bullish and invested, one assumes that few buyers remain. This leaves more potential
sellers than buyers, despite the bullish sentiment. This suggests that prices will trend down, and is an
example of contrarian trading.

Recently, Kim Man Lui, Lun Hu, and Keith C.C. Chan have suggested that there is statistical evidence of
association relationships between some of the index composite stocks whereas there is no evidence for
such a relationship between some index composite others. They show that the price behavior of these
Hang Seng index composite stocks is easier to understand than that of the index.

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The industry is globally represented by the International Federation of Technical Analysts (IFTA), which is
a Federation of regional and national organizations. In the United States, the industry is represented by
both the Market Technicians Association (MTA) and the American Association of Professional Technical
Analysts (AAPTA). The United States is also represented by the Technical Security Analysts Association
of San Francisco (TSAASF). In the United Kingdom, the industry is represented by the Society of
Technical Analysts (STA). In Canada the industry is represented by the Canadian Society of Technical
Analysts

Professional technical analysis societies have worked on creating a body of knowledge that describes the
field of Technical Analysis. A body of knowledge is central to the field as a way of defining how and why
technical analysis may work. It can then be used by academia, as well as regulatory bodies, in developing
proper research and standards for the field. TheMarket Technicians Association (MTA) has published a
body of knowledge, which is the structure for the MTA's Chartered Market Technician (CMT) exam.

 

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Since the early 1990s when the first practically usable types emerged, artificial neural networks (ANNs)
have rapidly grown in popularity. They are artificial intelligence adaptive software systems that have been
inspired by how biological neural networks work. They are used because they can learn to detect
complex patterns in data. In mathematical terms, they are universal function approximators, meaning that
given the right data and configured correctly, they can capture and model any input-output relationships.
This not only removes the need for human interpretation of charts or the series of rules for generating
entry/exit signals, but also provides a bridge to fundamental analysis, as the variables used in
fundamental analysis can be used as input.

As ANNs are essentially non-linear statistical models, their accuracy and prediction capabilities can be
both mathematically and empirically tested. In various studies, authors have claimed that neural networks
used for generating trading signals given various technical and fundamental inputs have significantly
outperformed buy-hold strategies as well as traditional linear technical analysis methods when combined
with rule-based expert systems.

While the advanced mathematical nature of such adaptive systems has kept neural networks for financial
analysis mostly within academic research circles, in recent years more user friendly neural network
software has made the technology more accessible to traders. However, large-scale application is
problematic because of the problem of matching the correct neural topology to the market being studied.

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John Murphy states that the principal sources of information available to technicians are price, volume
and open interest. Other data, such as indicators and sentiment analysis, are considered secondary.

However, many technical analysts reach outside pure technical analysis, combining other market forecast
methods with their technical work. One advocate for this approach is John Bollinger, who coined the
term  
 in the middle 1980s for the intersection of technical analysis and fundamental
analysis. Another such approach, fusion analysis, overlays fundamental analysis with technical, in an
attempt to improve portfolio manager performance.

Technical analysis is also often combined with quantitative analysis and economics. For example, neural
networks may be used to help identify intermarket relationships. A few market forecasters
combine financial astrology with technical analysis. Chris Carolan's article "Autumn Panics and Calendar
Phenomenon", which won the Market Technicians Association Dow Award for best technical analysis
paper in 1998, demonstrates how technical analysis and lunar cycles can be combined. Calendar
phenomena, such as the January effect in the stock market, are generally believed to be caused by tax
and accounting related transactions, and are not related to the subject of financial astrology.

Investor and newsletter polls, and magazine cover sentiment indicators, are also used by technical
analysts.

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Whether technical analysis actually works is a matter of controversy. Methods vary greatly, and different
technical analysts can sometimes make contradictory predictions from the same data. Many investors
claim that they experience positive returns, but academic appraisals often find that it has little predictive
power. Modern studies may be more positive: of 95 modern studies, 56 concluded that technical analysis
had positive results, although data-snooping bias and other problems make the analysis
difficult. Nonlinear prediction using neural networks occasionally produces statistically
significant prediction results. A Federal Reserve working paper regarding support and resistance levels in
short-term foreign exchange rates "offers strong evidence that the levels help to predict intraday trend
interruptions," although the "predictive power" of those levels was "found to vary across the exchange
rates and firms examined".

Technical trading strategies were found to be effective in the Chinese marketplace by a recent study that
states, "Finally, we find significant positive returns on buy trades generated by the contrarian version of
the moving average crossover rule, the channel breakout rule, and the Bollinger band trading rule, after
accounting for transaction costs of 0.50 percent."

An influential 1992 study by Brock et al. which appeared to find support for technical trading rules was
tested for data snooping and other problems in 1999; the sample covered by Brock et al. was robust to
data snooping.

Subsequently, a comprehensive study of the question by Amsterdam economist Gerwin Griffioen

concludes that: "for the U.S., Japanese and most Western European stock market indices the recursive
out-of-sample forecasting procedure does not show to be profitable, after implementing little transaction
costs. Moreover, for sufficiently high transaction costs it is found, by estimating CAPMs, that technical
trading shows no statistically significant risk-corrected out-of-sample forecasting power for almost all of
the stock market indices." Transaction costs are particularly applicable to "momentum strategies"; a
comprehensive 1996 review of the data and studies concluded that even small transaction costs would
lead to an inability to capture any excess from such strategies.

In a paper published in the Journal of Finance, Dr. Andrew W. Lo, director MIT Laboratory for Financial
Engineering, working with Harry Mamaysky and Jiang Wang found that "

Technical analysis, also known as "charting," has been a part of financial practice for many decades, but
this discipline has not received the same level of academic scrutiny and acceptance as more traditional
approaches such as fundamental analysis. One of the main obstacles is the highly subjective nature of
technical analysis²the presence of geometric shapes in historical price charts is often in the eyes of the
beholder. In this paper, we propose a systematic and automatic approach to technical pattern recognition
using nonparametric kernel regression, and apply this method to a large number of U.S. stocks from 1962
to 1996 to evaluate the effectiveness of technical analysis. By comparing the unconditional empirical
distribution of daily stock returns to the conditional distribution²conditioned on specific technical
indicators such as head-and-shoulders or double-bottoms²we find that over the 31-year sample period,
several technical indicators do provide incremental information and may have some practical value.

In that same paper Dr. Lo wrote that "several academic studies suggest that ... technical analysis may
well be an effective means for extracting useful information from market prices." Some techniques such
as Drummond Geometry attempt to overcome the past data bias by projecting support and resistance
levels from differing time frames into the near-term future and combining that with reversion to the mean
techniques.




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The efficient-market hypothesis (EMH) contradicts the basic tenets of technical analysis by stating that
past prices cannot be used to profitably predict future prices. Thus it holds that technical analysis cannot
be effective. Economist Eugene Fama published the seminal paper on the EMH in the 


 in 1970, and said "In short, the evidence in support of the efficient markets model is extensive,
and (somewhat uniquely in economics) contradictory evidence is sparse."

Technicians say that EMH ignores the way markets work, in that many investors base their expectations
on past earnings or track record, for example. Because future stock prices can be strongly influenced by
investor expectations, technicians claim it only follows that past prices influence future prices. They also
point to research in the field of behavioral finance, specifically that people are not the rational participants
EMH makes them out to be. Technicians have long said that irrational human behavior influences stock
prices, and that this behavior leads to predictable outcomes. Author David Aronson says that the theory
of behavioral finance blends with the practice of technical analysis:

By considering the impact of emotions, cognitive errors, irrational preferences, and the dynamics of group
behavior, behavioral finance offers succinct explanations of excess market volatility as well as the excess
returns earned by stale information strategies.... cognitive errors may also explain the existence of market
inefficiencies that spawn the systematic price movements that allow objective TA [technical analysis]
methods to work.

EMH advocates reply that while individual market participants do not always act rationally (or have
complete information), their aggregate decisions balance each other, resulting in a rational outcome
(optimists who buy stock and bid the price higher are countered by pessimists who sell their stock, which
keeps the price in equilibrium). Likewise, complete information is reflected in the price because all market
participants bring their own individual, but incomplete, knowledge together in the market.
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The random walk hypothesis may be derived from the weak-form efficient markets hypothesis, which is
based on the assumption that market participants take full account of any information contained in past
price movements (but not necessarily other public information). In his book 

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v  , Princeton economist Burton Malkiel said that technical forecasting tools such as pattern analysis
must ultimately be self-defeating: "The problem is that once such a regularity is known to market
participants, people will act in such a way that prevents it from happening in the future."

In the late 1980s, professors Andrew Lo and Craig McKinlay published a paper which cast doubt on the
random walk hypothesis. In a 1999 response to Malkiel, Lo and McKinlay collected empirical papers that
questioned the hypothesis' applicability that suggested a non-random and possibly predictive component
to stock price movement, though they were careful to point out that rejecting random walk does not
necessarily invalidate EMH, which is an entirely separate concept from RWH. In a 2000 paper, Andrew
Lo back-analyzed data from U.S. from 1962 to 1996 and found that "several technical indicators do
provide incremental information and may have some practical value".

Technicians say that the EMH and random walk theories both ignore the realities of markets, in that
participants are not completely rational and that current price moves are not independent of previous
moves.





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Technical analysis includes the study of past market data in relation to price and volume for the purpose
of forecasting future price movements. Technical analysis, however, does not help in making any
absolute predictions. Rather it only helps in projecting the "likely" price movements over time.

Technical analysis is applicable to futures, commodities, stocks, foreign exchange (forex), indices and
any tradable instrument, the price of which is affected by supply and demand trends. Day traders and
short-term investors participating in investment markets, like the stock market and the foreign exchange
(forex) market make use of technical analysis. This type of analysis also proves very useful for hedgers.


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Technical analysis is based on the principle that price discounts every aspect and information in the
market. Technical analysis also depends on the belief that price movements are never totally arbitrary
and follow a certain trend. A technical analyst believes that it's possible to identify an ongoing trend,
identify the trade based on the trend and generate profits as and when the trend unfolds. The methods
that are used for technical analysis include:

1. ð

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short term and long term. The most widely used moving averages are the 30-day moving average
(DMAs) and the 200-day moving average (DMAs).
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: Extensive charts are made depending on historical data on movements of
prices. These charts help in identifying patterns and shapes, such as double bottom, double top,
head and shoulders and triple bottom.



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Technical analysis is based on following three assumptions

1. The Market discounts everything.

2. Price moves in trends.
3. History tends to repeat itself.

1. The Market Discounts Everything

A major criticism on technical analysis is that it only considers price movements, leaving aside the
fundamental factors of a company. In reality, technical analysis assumes that, at any given time,
the price of a stock reflects everything that has or can affect the company - including the
fundamental factors. Technical analysts are of the opinion that the company's fundamentals,
along with the broader economic factors as well as market psychology, are all priced into the
 stock, thus removing the need to actually consider all these factors separately. This only leaves
the analysis of price movements, which technical analysis views as a product of supply and
demand for a particular stock in the market.

2. Price Moves in Trends

Technical analysis believes that price movements follow certain trends. This indicates that once a
trend has been established, then the future price movement is more likely to be in the same
direction as this trend than to be against it.

3. History Tends To Repeat Itself

Technical analysis also assumes an important idea that history tends to repeat itself, mainly in
terms of the price movement. The repetitive nature of the price movements is attributed to the
market psychology; indicating that, market participants tend to provide a steady reaction to similar
market stimuli over a period of time. Technical analysis makes use of chart patterns in order to
analyze market movements and understand trends. Even though many of these charts have been
used for over 100 years, they are still assumed to be relevant because they illustrate patterns in
price movements which often repeat themselves





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„ It helps in identifying a trend, thus allowing investors to predict future trends.

„ It allows investors to judge and understand the direction of the current trend; thus enabling them
to gauge which is the best time to take a position in the market.
„ When it is used in combination with fundamental analysis, company and industry related news, it
minimizes the chances of incurring losses for an investor.





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„ It depends greatly on a person's opinion and interpretation.

„ It is more a study of probabilities than of the actual value.
„ Useful only incase of short-term investments.
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Technical Analysis is the forecasting of future financial price movements based on an examination of past
price movements. Like weather forecasting, technical analysis does not result in absolute predictions
about the future. Instead, technical analysis can help investors anticipate what is "likely" to happen to
prices over time. Technical analysis uses a wide variety of charts that show price over time.
Technical analysis is applicable to stocks, indices, commodities, futures or any tradable instrument where
the price is influenced by the forces of supply and demand. Price refers to any combination of the open,
high, low, or close for a given security over a specific time frame. The time frame can be based on
intraday (1-minute, 5-minutes, 10-minutes, 15-minutes, 30-minutes or hourly), daily, weekly or monthly
price data and last a few hours or many years. In addition, some technical analysts include volume or
open interest figures with their study of price action.

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At the turn of the century, the Dow Theory laid the foundations for what was later to become modern
technical analysis. Dow Theory was not presented as one complete amalgamation, but rather pieced
together from the writings of Charles Dow over several years. Of the many theorems put forth by Dow,
three stand out:

„ Price Discounts Everything

„ Price Movements Are Not Totally Random
„ What Is More Important than Why

Price Discounts Everything

This theorem is similar to the strong and semi-strong forms of market efficiency. Technical analysts
believe that the current price fully reflects all information. Because all information is already reflected in
the price, it represents the fair value, and should form the basis for analysis. After all, the market price
reflects the sum knowledge of all participants, including traders, investors, portfolio managers, buy-side
analysts, sell-side analysts, market strategist, technical analysts, fundamental analysts and many others.
It would be folly to disagree with the price set by such an impressive array of people with impeccable
credentials. Technical analysis utilizes the information captured by the price to interpret what the market
is saying with the purpose of forming a view on the future.

Prices Movements are not Totally Random

Most technicians agree that prices trend. However, most technicians also acknowledge that there are
periods when prices do not trend. If prices were always random, it would be extremely difficult to make
money using technical analysis. In his book, v
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A technician believes that it is possible to identify a trend, invest or trade based on the trend and make
money as the trend unfolds. Because technical analysis can be applied to many different time frames, it is
possible to spot both short-term and long-term trends. The IBM chart illustrates Schwager's view on the
nature of the trend. The broad trend is up, but it is also interspersed with trading ranges. In between the
trading ranges are smaller uptrends within the larger uptrend. The uptrend is renewed when the stock
breaks above the trading range. A downtrend begins when the stock breaks below the low of the previous
trading range.

"What" is More Important than "Why"

In his book,




 
, Tony Plummer paraphrases Oscar Wilde by stating,
"A technical analyst knows the price of everything, but the value of nothing". Technicians, as technical
analysts are called, are only concerned with two things:

1. What is the current price?

2. What is the history of the price movement?

The price is the end result of the battle between the forces of supply and demand for the company's
stock. The objective of analysis is to forecast the direction of the future price. By focusing on price and
only price, technical analysis represents a direct approach. Fundamentalists are concerned with why the
price is what it is. For technicians, the why portion of the equation is too broad and many times the
fundamental reasons given are highly suspect. Technicians believe it is best to concentrate on what and
never mind why. Why did the price go up? It is simple, more buyers (demand) than sellers (supply). After
all, the value of any asset is only what someone is willing to pay for it. Who needs to know why?

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Many technicians employ a top-down approach that begins with broad-based macro analysis. The larger
parts are then broken down to base the final step on a more focused/micro perspective. Such an analysis
might involve three steps:

1. Broad market analysis through the major indices such as the S&P 500, Dow Industrials, NASDAQ
and NYSE Composite.
 2. Sector analysis to identify the strongest and weakest groups within the broader market.
3. Individual stock analysis to identify the strongest and weakest stocks within select groups.

The beauty of technical analysis lies in its versatility. Because the principles of technical analysis are
universally applicable, each of the analysis steps above can be performed using the same theoretical
background. You don't need an economics degree to analyze a market index chart. You don't need to be
a CPA to analyze a stock chart. Charts are charts. It does not matter if the time frame is 2 days or 2
years. It does not matter if it is a stock, market index or commodity. The technical principles of support,
resistance, trend, trading range and other aspects can be applied to any chart. While this may sound
easy, technical analysis is by no means easy. Success requires serious study, dedication and an open
mind.

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Technical analysis can be as complex or as simple as you want it. The example below represents a
simplified version. Since we are interested in buying stocks, the focus will be on spotting bullish
situations.
  
 The first step is to identify the overall trend. This can be accomplished with trend
lines, moving averages or peak/trough analysis. As long as the price remains above its uptrend line,
selected moving averages or previous lows, the trend will be considered bullish.

 Areas of congestion or previous lows below the current price mark support levels. A break
below support would be considered bearish.

 


 Areas of congestion and previous highs above the current price mark the resistance levels.
A break above resistance would be considered bullish.
ð
 Momentum is usually measured with an oscillator such as MACD. If MACD is above its 9-
day EMA (exponential moving average) or positive, then momentum will be considered bullish, or at least
improving.



 

c   For stocks and indices with volume figures available, an indicator that uses
volume is used to measure buying or selling pressure. WhenChaikin Money Flow is above zero, buying
pressure is dominant. Selling pressure is dominant when it is below zero.

 
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  The price relative is a line formed by dividing the security by a benchmark. For stocks
it is usually the price of the stock divided by the S&P 500. The plot of this line over a period of time will tell
us if the stock is outperforming (rising) or under performing (falling) the major index.

The final step is to synthesize the above analysis to ascertain the following:

„ Strength of the current trend.

„ Maturity or stage of current trend.
„ Reward to risk ratio of a new position.
„ Potential entry levels for new long position.

 
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For each segment (market, sector and stock), an investor would analyze long-term and short-term charts
to find those that meet specific criteria. Analysis will first consider the market in general, perhaps the S&P
500. If the broader market were considered to be in bullish mode, analysis would proceed to a selection
of sector charts. Those sectors that show the most promise would be singled out for individual stock
analysis. Once the sector list is narrowed to 3-4 industry groups, individual stock selection can begin.
With a selection of 10-20 stock charts from each industry, a selection of 3-4 of the most promising stocks
in each group can be made. How many stocks or industry groups make the final cut will depend on the
strictness of the criteria set forth. Under this scenario, we would be left with 9-12 stocks from which to
choose. These stocks could even be broken down further to find the 3-4 of the strongest of the strong.


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Focus on Price

If the objective is to predict the future price, then it makes sense to focus on price movements. Price
movements usually precede fundamental developments. By focusing on price action, technicians are
automatically focusing on the future. The market is thought of as a leading indicator and generally leads
the economy by 6 to 9 months. To keep pace with the market, it makes sense to look directly at the price
movements. More often than not, change is a subtle beast. Even though the market is prone to sudden
knee-jerk reactions, hints usually develop before significant moves. A technician will refer to periods
of accumulation as evidence of an impending advance and periods of distribution as evidence of an
impending decline.

Supply, Demand, and Price Action

Many technicians use the open, high, low and close when analyzing the price action of a security. There
is information to be gleaned from each bit of information. Separately, these will not be able to tell much.
However, taken together, the open, high, low and close reflect forces of supply and demand.
The annotated example above shows a stock that opened with a gap up. Before the open, the number of
buy orders exceeded the number of sell orders and the price was raised to attract more sellers. Demand
was brisk from the start. The intraday high reflects the strength of demand (buyers). The intraday low
reflects the availability of supply (sellers). The close represents the final price agreed upon by the buyers
and the sellers. In this case, the close is well below the high and much closer to the low. This tells us that
even though demand (buyers) was strong during the day, supply (sellers) ultimately prevailed and forced
the price back down. Even after this selling pressure, the close remained above the open. By looking at
price action over an extended period of time, we can see the battle between supply and demand unfold.
In its most basic form, higher prices reflect increased demand and lower prices reflect increased supply.

Support/Resistance

Simple chart analysis can help identify support and resistance levels. These are usually marked by
periods of congestion (trading range) where the prices move within a confined range for an extended
period, telling us that the forces of supply and demand are deadlocked. When prices move out of the
trading range, it signals that either supply or demand has started to get the upper hand. If prices move
above the upper band of the trading range, then demand is winning. If prices move below the lower band,
then supply is winning.

Pictorial Price History

Even if you are a tried and true fundamental analyst, a price chart can offer plenty of valuable information.
The price chart is an easy to read historical account of a security's price movement over a period of time.
Charts are much easier to read than a table of numbers. On most stock charts, volume bars are displayed
at the bottom. With this historical picture, it is easy to identify the following:

„ Reactions prior to and after important events.

„ Past and present volatility.
„ Historical volume or trading levels.
„ Relative strength of a stock versus the overall market.
Assist with Entry Point

Technical analysis can help with timing a proper entry point. Some analysts use fundamental analysis to
decide what to buy and technical analysis to decide when to buy. It is no secret that timing can play an
important role in performance. Technical analysis can help spot demand (support) and supply
(resistance) levels as well as breakouts. Simply waiting for a breakout above resistance or buying near
support levels can improve returns.

It is also important to know a stock's price history. If a stock you thought was great for the last 2 years has
traded flat for those two years, it would appear that Wall Street has a different opinion. If a stock has
already advanced significantly, it may be prudent to wait for a pullback. Or, if the stock is trending lower, it
might pay to wait for buying interest and a trend reversal.

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Analyst Bias

Just as with fundamental analysis, technical analysis is subjective and our personal biases can be
reflected in the analysis. It is important to be aware of these biases when analyzing a chart. If the analyst
is a perpetual bull, then a bullish bias will overshadow the analysis. On the other hand, if the analyst is a
disgruntled eternal bear, then the analysis will probably have a bearish tilt.

Open to Interpretation

Furthering the bias argument is the fact that technical analysis is open to interpretation. Even though
there are standards, many times two technicians will look at the same chart and paint two different
scenarios or see different patterns. Both will be able to come up with logical support and resistance levels
as well as key breaks to justify their position. While this can be frustrating, it should be pointed out that
technical analysis is more like an art than a science, somewhat like economics. Is the cup half-empty or
half-full? It is in the eye of the beholder.

Too Late

Technical analysis has been criticized for being too late. By the time the trend is identified, a substantial
portion of the move has already taken place. After such a large move, the reward to risk ratio is not great.
Lateness is a particular criticism of Dow Theory.

Always Another Level

Even after a new trend has been identified, there is always another "important" level close at hand.
Technicians have been accused of sitting on the fence and never taking an unqualified stance. Even if
they are bullish, there is always some indicator or some level that will qualify their opinion.

Trader's Remorse

Not all technical signals and patterns work. When you begin to study technical analysis, you will come
across an array of patterns and indicators with rules to match. For instance: A sell signal is given when
the neckline of a head and shoulders pattern is broken. Even though this is a rule, it is not steadfast and
can be subject to other factors such as volume and momentum. In that same vein, what works for one
particular stock may not work for another. A 50-day moving average may work great to identify support
and resistance for IBM, but a 70-day moving average may work better for Yahoo. Even though many
principles of technical analysis are universal, each security will have its own idiosyncrasies.
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Technical analysts consider the market to be 80% psychological and 20% logical. Fundamental analysts
consider the market to be 20% psychological and 80% logical. Psychological or logical may be open for
debate, but there is no questioning the current price of a security. After all, it is available for all to see and
nobody doubts its legitimacy. The price set by the market reflects the sum knowledge of all participants,
and we are not dealing with lightweights here. These participants have considered (discounted)
everything under the sun and settled on a price to buy or sell. These are the forces of supply and demand
at work. By examining price action to determine which force is prevailing, technical analysis focuses
directly on the bottom line: What is the price? Where has it been? Where is it going?

Even though there are some universal principles and rules that can be applied, it must be remembered
that technical analysis is more an art form than a science. As an art form, it is subject to interpretation.
However, it is also flexible in its approach and each investor should use only that which suits his or her
style. Developing a style takes time, effort and dedication, but the rewards can be significant.