An Introduction to Technical Analysis
What is Technical Analysis and Does it Work?
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Fundamental vs Technical
There are two main approaches to investment analysis.
Fundamental analysis seeks to value an investment based upon all known relevant facts. These could be facts about the investment itself, eg the current situation within the corporation, its business environment, the national and global economy. The idea is to discover investments selling for less than suggested by these fundamentals.
The problem with fundamental analysis is that the market consists of numerous players, many of whom are highly sophisticated, between whom information is flowing at the speed of thought. If you as a private investor discover an under-valued stock, is it because you have truly uncovered something this large and complex entity has missed? Or, more likely, have you missed something that the market as a whole has already factored into its price?
In contrast, technical analysis is unconcerned with underlying economic and financial fundamentals. Instead it attempts to predict future price movements based solely on past price movements and other trading patterns. One might consider such an approach to have as much chance of success as picking investments according to the movement of the stars, but technical analysis does have a significant number of adherents and is attracting growing interest in the relatively new arena of foreign exchange trading.
Academic, and successful investor Burton G Malkiel is scathing of technical analysis stating that computer analyses of technical trading methods have performed no better than chance after deduction of trading fees. In his classic "A Random Walk Down Wall Street" Malkiel writes: "Curiously, however, the broken technician is never apologetic about his method. If anything, he is more enthusiastic than ever. If you commit the social error of asking him why he is broke, he will tell you quite ingeniously that he made the all-too-human error of not believing his own charts. To my great embarrassment, I once choked conspicuously at the dinner table of a chartist friend of mine when he made such a comment. I have since made it a rule never to eat with a chartist. It's bad for digestion."
However, experience has shown and continues to show, that markets are not wholly rational places. Despite the proliferation of sophisticated mathematical models and powerful computer hardware and software, human psychology (or the madness of crowds) still plays a (the?) leading role in price determination.
There is an argument that the technician's (technical analysis practitioner's) charts encapsulate trading behavior and that technical analysis may even be a self-fulfilling prophesy as participants both perceive and then act upon classic technical signals. This may be especially true in the short term.
This article continues by describing describes the key elements of technical analysis. It does not attempt to deliver a definitive verdict on its effectiveness, rather it leaves it to the reader to experiment and reach his/her own conclusions.
Recommended Reading
Technical Analysis for Dummies
Barbara Rockefeller. A simple, straightforward guide to the fundamentals of technical analysis.
For active traders and investors who don't understand the complicated art of technical analysis, this commonsense resource covers all the bases. Explaining the basic principles of analysis and showing how to implement them, Technical Analysis For Dummies dumps the confusing jargon and unreadable charts for basic explanations and practical guidance. In no time at all, readers will see how to make better trading decisions.
Technical Analysis of the Financial Markets: A Comprehensive Guide to Trading Methods and Applications John J. Murphy This outstanding reference has already taught thousands of traders the concepts of technical analysis and their application in the futures and stock markets. Covering the latest developments in computer technology, technical tools, and indicators, the second edition features new material on candlestick charting, intermarket relationships, stocks and stock rotation, plus state-of-the-art examples and figures. From how to read charts to understanding indicators and the crucial role technical analysis plays in investing, readers gain a thorough and accessible overview of the field of technical analysis, with a special emphasis on futures markets. Revised and expanded for the demands of today's financial world, this book is essential reading for anyone interested in tracking and analyzing market behavior.