Technical analysis (in the field of finance) is a methodology for analyzing a financial instrument for predicting the direction of price movement based on the study of past market data, primarily price and volume. Behavioral economics and quantitative analysis use many of the same tools of technical analysis, which, being one of the aspects of active management, are in conflict with most of the modern portfolio theory. The effectiveness of both technical and fundamental analysis is challenged by the efficient market hypotheses, which state that stock market prices are essentially unpredictable. Technical analysis in the Forex market involves trading based on the analysis of the dynamics of quotations.
History of using technical analysis
The principles of technical analysis stem from information about financial markets that are hundreds of years old. Some aspects of technical analysis began to appear in the accounts of Joseph de la Vega in the Dutch markets in the 17th century. As they say in Asia, technical analysis is a method developed by Homma Munehis in the early 18th century, which developed using candle methods and today is a graphical tool for technical analysis. In the 1920s and 1930s, Richard W. Schabaker published several books that continued the work of Charles Dow and William Peter Hamilton – "The theory and Practice of the Stock market and technical analysis of the market". In 1948, Robert D. Edwards and John Magee published the book "Technical Analysis of Trends in the stock market", which is considered one of the fundamental works on this discipline. It concerns exclusively the analysis of trends and graphical models and is still used at the present time. As you can see, in the beginning, technical analysis was almost exclusively graphical analysis, because the computing capabilities of computers were not available for statistical analysis. According to available data, Charles Dow invented a form of point-to-digital graph analysis.
Dow theory is based on the collected works of Dow Jones, co-founder and editor Charles Dow, and encourages the use and development of modern technical analysis in the late 19th century. Other innovators of analytical methods were Ralph Nelson Elliott, William Delbert Gunn and Richard Wyckoff, who developed their respective methods at the beginning of the 20th century. More detailed technical tools and theories have been developed and improved in recent decades, with the introduction of computer technology assisted by the use of specially developed software.
Technical Analysis Characteristics
Technical analysis uses models and trading rules that are based on the transformation of prices and volumes, such as the relative strength index, moving averages, regressions, inter-market and intra-market price correlations, business cycles, stock market cycles, or on the recognition of classical graphical patterns.
Technical analysis differs from fundamental analysis, which is based on the analysis of currency pairs. Technical analysis analyzes price, volume and other market information, while fundamental analysis focuses on the facts of the company, market, currency or commodity. Most large brokerage, trading groups, or financial institutions, as a rule, contain divisions that conduct both technical analysis and fundamental analysis.
Technical analysis is widely used by traders and financial specialists, and is also very often used by active intraday traders, market makers and commodity exchange brokers. Users believe that even if technical analysis cannot predict the future, it helps to determine trading opportunities.
In the foreign exchange markets, its use may be broader than fundamental analysis. This does not mean that technical analysis is more applicable to foreign markets, but that technical analysis is more recognizable in order to apply it effectively here than anywhere else. While some individual studies have shown that technical trading rules can lead to consecutive returns in the period before 1987, most of the theoretical work has focused on the nature of the abnormal position of the foreign exchange market. It was assumed that this anomaly was due to the intervention of the central bank, which, obviously, technical analysis could not predict. Recent studies show that by combining various trading signals into a single approach, it is possible to increase profitability and reduce dependence on any one rule.
Principles of technical analysis
The fundamental principle of technical analysis is that the price on the market reflects all the necessary information, so its analysis is carried out from the point of view of the history of the trading picture of this asset (or currency pair), without taking into account external factors such as economic, fundamental and news events. Thus, the price action tends to be repeated due to the fact that investors collectively tend to find certain patterns on the chart. Therefore, technical analysis focuses on identifiable trends and conditions.
Based on the fact that all relevant information is already reflected in the price, technical analysts believe that it is important to understand what investors think about this or that information that is known and perceived by everyone.
Analysis of market trends
Technical analysts believe that all price trends have a direction, that is, trends can be ascending, descending or sideways, or there are combinations of them. The main definition of the price trend was originally put forward by the Dow theory.
Analysis of investor behavior in the market
Technical analysts believe that investors collectively repeat the behavior of previous investors. For a technical analyst, emotions in the market may be unreasonable, but, nevertheless, they exist. Because, according to the opinions of technical analysts, the behavior of investors is repeated as often as recognizable (and predictable) price patterns will develop on the chart. Recognizing these patterns can allow a technician to choose a deal that will have a higher probability of success.
Technical analysis is not limited to charts, but it is always based on price trends. For example, many technical analysts monitor investor sentiment. These studies assess the attitude of market participants, in particular, whether they are really set up for a bearish or bullish trend. Technical analysts use these surveys to help determine whether the trend will continue, or a reversal may develop. When such surveys report extreme investor sentiment, they are likely to expect changes. For example, studies that show that investors are becoming as bullish as possible are evidence that an uptrend may reverse; the prerequisites for the fact that most investors are becoming bullish indicate that they have all already bought in the market (anticipating higher prices). And therefore, the more bullish the majority of investors become, it means that the bulk of them have already made a purchase, and we can assume that there are few buyers left on the market. This suggests that there are more potential sellers than buyers in the market, despite the bullish mood. And, consequently, prices will decline, which is a signal for changing the trade to the opposite.
Recently, Kim Man Lui, Lun Hu and Keith C. C. Chan have suggested that if there are statistical data of associative relationships between some of the composite indices of one of the stock exchanges, then there is no evidence of such a relationship between some of the composite indices of other stock exchanges. They show that the price behavior of the Hang Seng Stock Exchange indices is easier to understand than the behavior of other indices.