Principles of Technical Analysis
Technical analysis or "charting" is the study of price and volume behavior in financial markets in order to anticipate their future performance. I have deliberately used the word "anticipate" rather than "forecast" or "predict":
The market can go up or down at any time — it is only the probability (of each move) that varies.
Foundations of Technical Analysis
Technical analysis is based on three basic beliefs:
- Price discounts everything.
All fundamental, political and economic information available to the market is reflected in the price. - Price tends to move in trends.
Charles Dow developed the Dow Theory based on his empirical observation of trends more than a century ago. - History tends to repeat itself.
Basic human nature does not change and the market, reflecting the sum of all participants actions, behaves in identifiable patterns.
Does Technical Analysis Work?
Some academic studies claim that price movements in financial markets are entirely random, with no recognizable pattern. Other studies have shown that buy and sell orders are not randomly distributed -- they tend to cluster around key price levels in the market -- the basic tenet of support and resistance.
Support and Resistance
Support and resistance — the behavior of buyers and sellers at key price levels — is the foundation of all classical technical analysis.
- Trend theory is based on the performance of price at key support and resistance levels.
- Chart patterns similarly identify the behavior of buyers and sellers in relation to support and resistance.
Not an Exact Science
A word of caution: Technical Analysis should not be used to make predictions. We never know the outcome of a particular pattern or series of events with 100 per cent certainty. The best that we can hope to achieve is a probability of around 80 per cent for any particular outcome, which means that something unexpected will occur at least one in five times.
Our approach is to assign probabilities to each possible outcome. Assigning actual percentages would imply a degree of precision which, is normally unachievable. Most of the time, however, we can tell that price is at least twice as likely to move in a certain direction, as it is to move in the other. That is sufficient edge for a good trader to out-perform the general market.
How to Study Technical Analysis
It is important to build a sound understanding of the basic concepts before progressing to indicators and more complex chart patterns.
All that indicators do is summarize price and volume behavior in different ways to highlight important features. Bear in mind that whenever you summarize you sacrifice. All that an indicator does is to present a particular feature of the data in a more readable format — while eliminating all other features.
Indicators, in the right hands, are important tools but they cannot substitute for sound basic technical analysis. The big picture, that presents all the data, is always the price and volume chart.