Technical Stock Analysis

Technical analysis, also known as charting or chart analysis, is a method of studying the trading history (the price and volume over time) and market action via graphic representations of any type of traded security (stocks, commodities, etc.) to attempt to predict future prices. Chart analysis is, in essence, the study of a segment of history recorded in picture rather than text.

A chart can express vast amounts of data almost instantaneously. If you were going to try and display the volume of numbers and number relationships that are displayed graphically via a chart in text form, it would be impossible to mentally process all this information in a useful way. This is the key reason why using stock charts is such a powerful tool.

Technical analysis (studying the price and trading history) stands in contrast to fundamental analysis (studying the actual nature of the stock or commodity in question), although some investors combine the two types of analysis in making investment decisions.

Technical analysis is primarily (but not exclusively) conducted by studying charts of past price and trading action. The chartist looks for recurring patterns for the purpose of predicting future short-term price movements.

Many different methods and tools are used in technical analysis, but they all rely on the assumption that price patterns and trends exist in markets, and that they can be identified and exploited.

But like with any other trading tool, system and strategy, technical analysis is also not 100% accurate, but attempts to give results that are, simply, correct more often than they are wrong.

The study of technical analysis can become quite complex and esoteric. So I will offer a little warning here. It is easy for a trader who relies overly on chart patterns as a major component in the decision making process to project his hopes, fears and expectations into the charts. This over-reliance most often takes the form of applying a whole variety of indicators, techniques and tricks to a chart making it difficult to make good trades.

Applying numerous and all different kinds of indicators is not going to enhance the performance of your trading account. So don't be an "Indicator Abuser" and use only up to 3, but never more than 4 indicators on a chart!

For clarity, the term "indicator" refers to any mathematical calculation that is represented graphically upon a chart. Some of the widely-known indicators are:

Technical analysis is not concerned with why a price is moving (e.g. poor earnings, difficult business environment, poor management, or other fundamentals) but rather whether it is moving in a particular direction or in a particular chart pattern. Technical analysts believe that profits can be made by "Trend Following." In other words if a particular stock price is steadily rising (trending upward) then a technical analyst will look for opportunities to buy this stock.

Until the technical analyst is convinced this uptrend has reversed or ended, all else equal, he will continue to own this security. Additionally, technical analysts look for various price patterns to form on a price chart and will take positions in anticipation of the expected move following that pattern. The tools of technical analysis are believed to assist the technician in determining when trends have formed, ended, etc. and when particular patterns are unfolding.

For example, a popular technical analysis tool is a stock price's 200 day moving average. This is usually defined as the average closing price of a stock over the past 200 trading days (though there are many variations on the moving average used in technical analysis). A stock that has been trending higher will have a history of an increasing daily stock price and an increasing 200 day moving average. Though the daily stock price fluctuates (up 50 cents on day 1, down 20 cents on day 2, up 10 cents on day 3, etc.), the 200 day moving average changes much more slowly and traces a smooth curve that follows the current price on a chart.

When the 200 day moving average is violated by the daily stock price, a technical analyst uses this as strong evidence that a price trend has ended and that possibly a new one has begun to the opposite direction. Suppose IBM's 200 day moving average was 85 and the stock has been trending higher. If IBM closed at 84.50, then a technical analyst would consider selling his IBM holdings and perhaps selling short IBM because the perceived trend is ending.

The above example illustrates a few important characteristics and potential shortfalls of technical analysis. Much of technical analysis is art and open to some varying interpretation. One technical analyst might believe that IBM would need to trade below its movind average for two consecutive days before declaring its trend over. Another might say one day is adequate. To a technician a close below the 200 day moving average is always important, but two technicans might disagree on the best way to act. Still, it is safe to assume that both technicians expect to sell IBM.

The obvious problem in this example is: what if in the near term IBM climbs back above its 200 day moving average after the technician sells his stock? If the technical analyst follows his own rules then he might be buying stock back at a higher price than he just sold plus commissions. This is a substantial component of some of the criticisms of technical analysis (see below). Technical analysis says "false signals" or "whipsaws" are an unavoidable part of using technical analysis. To a technical analyst, the costs of these whipsaws are far outweighed by catching a stock at the beginning of a new long term trend. Some research disputes this assertion however.

Technical analysis may be at odds with fundamental analysis. Fundamental analysis maintains that markets may misprice a security and, through various methods of fundamental analysis, the "correct" price can be calculated. Profits can be made by trading the mispriced security and then waiting for the market to recognize its "mistake" and reprice the security. In contrast, a technical analyst is not interested in a security's "correct" price, only in price movement.

Two well known sayings among technical analysts are, "The trend is your friend," and "Forget the fundamentals and follow the money." An example of the different views of technical and fundamental analysis follows. Suppose a stock was trading at $24, and that the consensus fundamental analysis view of the stock was that it was worth $20. If the share price rose to $25, then to $26, and then to $27, a technical analyst would likely be a buyer of this stock in order to profit from the perceived trend. In contrast, a fundamental analyst would possibly look to sell the stock as it is moving away from what the fundamental analyst believes is the correct price.

Technical analysis is to decode the signals generated from the market. Technical analysts believe it
works because they hold that because every possible bit of information will be reflected by means of
market action.

History tends to repeat itself

Technical analysts believe that investors en masse repeat the behavior of the investors that preceded them. "Everyone wants in on the next Microsoft," "If this stock ever gets to $50 again, I will buy it," "This company's technology will revolutionize its industry, therefore this stock will skyrocket,"-- these are all examples of investors' attitudes repeating. To a technical analyst, the human characteristics of the market might be irrational, but they exist. Because investors' attitudes often repeat, investors' actions in the marketplace often repeat as well. I.e., patterns of price movement will develop on a chart that a technical analyst believes have predictive qualities.

Technical analysis is not limited to charting. Technical analysis is always primarily concerned with price trends. Anything that can influence the price trend is of interest to a technical analyst. As an example, many technical analysts monitor surveys of investor enthusiasm. These surveys attempt to gauge the general attitude of the investment community to determine whether investors are bearish or bullish. Technical analysts use these surveys to help determine whether a trend will reverse or whether a new trend will develop.

A technical analyst would be alerted that a trend might change when these surveys report extreme investor reactions. When surveys are overly bullish, for example, a technical analyst will look for evidence that an uptrend will reverse. The logic being that if most investors are bullish, then they would have already bought the market (anticipating that the market will move higher).

But because most investors are bulllish and have invested, it is safe to assume that there are few buyers remaining in the market. With most investors long, there are more potential sellers in the market than buyers despite the fact that the overall attitude of investors is bullish. This implies that the market is set to trend down and is an example of a technical analysis concept called contrarian trading.

Technical analysis is the study of price and volume for the purpose of forecasting price trends, primarily through the use of charts. It's built around 3 key assumptions.

One of the major presumptions of technical analysis is that prices move in trends. A trader would plot price movements on a chart in an attempt to identify a trend so he can trade with it. This is usually done as a trend reverses or very early in an already existing trend.

The next major presumption of technical analysis is that prices shoul reflect changes in supply and demand. In other words, if the demand is greater than the supply, prices should rise. Vice-versa, if the supply is greater than the demand, prices should fall. Therefore, anything that has affected or could affect the price of a stock will be reflected in the price and on the chart.

The third presumption is that history repeats itself. This is a logical conclusion because a chart is a picture of price movement over time and a psychological picture of the emotions of the market players. Because humans are emotional creatures who have the tendancy to overreact, charts visually represent how the crowd has reacted to any given circumstance. One then concludes that in similar circumstances, the crowd will react in the same or similar way.

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