Foundations of Technical Analysis

Oct 27, 2008: 10:57 AM CST

With technical analysis – the art of studying price and volume through visual charting and mathematical indicators – gaining momentum, I thought it would be prudent to take a moment to discuss the three underlying foundations of modern technical analysis and why they’re important.  Let’s examine them:

1.  Prices Move in Observable Trends

Prices have direction, or flow, which is observable through price pulses (waves) that form swing highs and swing lows.  Objective measuring of these respective swing highs and swing lows constitute rudimentary measuring of the direction of a security’s or market’s price.  Often a linear regression line or analysis through certain moving averages can also be beneficial in assessing a market’s overall direction.

The basic premise – as described by Charles Dow and many others – is that “the observed trend should be assumed to continue until the weight of the evidence has shifted in favor of a reversal.”  In other words, you’ll have greater ease in trading if you trade in the direction of an observed trend.

Price moves through imbalances in supply and demand, and these imbalances lead to price expansion and contraction as perceived “value” is discovered to be at a progressively higher or lower price.

2.  Market Action Discounts Everything

“All information (knowns and ‘unknowns’) is already factored into price, or is discounted immediately.”

As such, price and the auction process is an efficient discounting mechanism such that new information and even rumors of new information are acted upon instantly and assimilated by traders, investors, and funds as they interact in a market.

This principle also gives rise to the concept “Buy the Rumor, Sell the Fact” and helps explain why a stock price might fall when a positive earnings report or other seemingly good company news is released.

Chartists argue that the current price (and its movement) reflect the purest assessment of a company or a particular market, and that price study is a ‘shortcut’ to complex fundamental analysis that can yield a clearer picture.  Charting also allows for instant cross-market analysis, eliminating the need to be an expert on a particular company, industry, sector, commodity, or foreign economy.

3.  History Repeats Itself

Price patterns (such as triangles, double-tops) were created by investor behavior at a certain time, and the similar currents that formed those patterns in the past tend to repeat into the future according to the underlying supply/demand picture a particular pattern creates.

Investors cycle through greed and fear (among other emotions) and a larger market cycle plays out indefinitely in response to similar information.  To put it crassly, investors tend to make the same mistakes over and over again (such as getting overly excited after a long market advance and getting overly pessimistic after a sharp market correction… or buying at market tops and selling at market bottoms).

Certain events trigger similar behaviors which appear as documented patterns (such as the head and shoulders) on price charts.  The Elliott Wave “Five Wave” impulse pattern may also help explain this (as investor psychology shifts from disbelief to realization to over-optimism).

Conclusion:

This is just a simple list of the three ‘academic’ reasons for the support of technical analysis (charting) as a market discipline which continues to grow in popularity.  For more information, check out the Wikipedia article on Technical Analysis which restates these points and draws more history and information on the page, as well as providing a good list of introductory books for more serious study on the topic.

Published by Corey Rosenbloom of Afraid to Trade.

6 Comments

6 Responses to “Foundations of Technical Analysis”

  1. Kris Says:

    Corey,

    Just a question about point no 2- as fas as I remember from my CFA studies, the notion that market discounts everything (known and unknowns) is a virtue of a strong-form efficiency, so the most efficient form of Efficient-market hypothesis. This form says basically that neither technical analysis, nor fundamental one, neither insider knowledge can affect and thus help predict price/volume movements. I am therefore puzzled by reading that this is one of the principles of technical analysis… By the way, really great blog, thanks for your insights and good luck with your work.

  2. Corey Rosenbloom Says:

    Kris,

    Thank you for reading and for your comment.

    There’s close overlap in the two assumptions, but TA takes into account mispricing due to emotion/sentiment/biases/errors etc that also affect security pricing (as in tech bubble and bust of 2000) that depart from fundamental valuation.

    While market forces efficiently price what can be known, collective emotions – and now collective algorithms (large scale quant fund trading) skew fundamental valuation.

    If prices were completely efficient, there would be periods of low volatility with an immediate jump in stock prices (similar to the chart of BUD) and little to no movement in-between.

    We do observe price swings, reactions to key technical indicators (Fibonacci, moving averages, oscillators, etc) which give us clues that people do act upon technical information, thus seemingly creating a ‘self-fulfilling prophecy’ that also deviates from fundamental valuation.

    Still, we have evidence that some funds/traders do consistently beat the market, which is due to some semblance of edge, but that the edge is not salient (in that strategies must evolve to changing market conditions).

    It’s probably a topic too large to be discussed here – I just wanted to show the underpinings for why traders embark in technical work and what some of the main pillars are.

  3. Dave Says:

    Nothing discounts everything, but the market comes closest. Are we done with the academic canard known as EMH?

  4. Corey Rosenbloom Says:

    Dave,

    I’d like to be done with the EMH, but it’s too well-entrenched academically. The books “Beyond Fear and Greed” and “Irrational Exuberance” go a long way at debunking the notion that markets are 100% infallibly efficient.

    Markets are quick to discount information and are forward-looking mechanisms, but they’re not perfect because humans are not perfect and are not always rational. Price can deviate from agreed-upon fundamental valuation for months or longer. Emotions and biases affect decision-making, and even algorithmic funds are subject to programmer bias/error.

    I’ve heard traders/fund managers say they made their fortunes off those who believed in the EMH so when push comes to shove, the proof is in the pudding… or profits.

  5. TA Says:

    The logical conflict between EMH and technical analysis is there only because Murphy decided that the price discounting mechanism was one of the pillars of technical analysis, whereas even the mild form of EMH says you should not be able to make money with using historical prices in trading.

    Clearly the information discounting mechanism is flawed, and so is EMH, and so is the pillar of using the information discounting mechanism as the reason to use TA.

    Although, some academic should take time to study how opinions are formed on a price, and how that transforms to a trend, and how that benefits TA, so in the end, the information discounting mechanism does benefit the strategy, but not by discounting all information.

  6. Khanzada Says:

    It is really lovely reading all this since it help us knowing what has happened in the past and also whenever we try to learn about it we get better understanding due to knowing of the past. It is very important that we learn to do all kind of analysis proper since that is the difference between a newbie and expert. I mostly trade with OctaFX broker and they have quality expert analysis service, it has so far given me average of above 80-85% results which are phenomenal.