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Technical Analysis

They are, in short, the un-erasable fingerprints of human nature made graphic in the greatest struggle, next to war, in human experience

Technical Analysis is the only system of analysis that incorporates the only explanation of market behavior. Technical analysis is research of market dynamics that is done mainly with the help of charts and with the purpose of forecasting future price development. Technical analysis comprises several approaches to the study of price movement which are interconnected in the framework of one harmonious theory. This type of analysis studies the price movement on the market by means of analyzing three market factors: price, volumes, and, in case of study of futures contracts’ market, of an open interest (number of open positions). Of these three factors the primary one for technical analysis is the prices, while the alterations in other factors are studies mainly in order to confirm the correctness of the identified price trend. This technical theory, just like any theory, has its core postulates.

They are the depiction of of multifarious human actions bearing on a single variable (price).  On price converge a galaxy of influences: fear, greed, desire, cunning, malice. deceit, naivete, earnings estimates, broker need for income, gullibility, professional money managers’ need for performance and job security, supply and demand of stocks, monetary liquidity and money flow, self-destructiveness, passivity, trap setting, manipulation, blind arrogance, conspiracy and fraud and double dealing, phases of the moon and sun spots, economic cycles and beliefs about them, public mood, and the indomitable human need to be right.

Chart formations are the language of the market, telling us that this stock is in its death throes; that stock is on a rocket to the moon; that a life and death battle is being wages in this issue; and in that other, the buyers have defeated the sellers and are breaking away.

“That which has been is that which will be, And that which has been done is that which will be done. So there is nothing new under the sun.” – Ecclesiastes 1:9

The Importance

The importance of technical analysis is multifaceted.

First, while fundamental analysis may provide a gauge of the supply/demand situations (i.e., price/earnings ratios, economic statistics) and so forth, there is no psychological component involved in such analysis.  Yet the markets are influenced at times, to a major extent, by emotionalism.  AS John Maynard Keynes stated, “There is nothing so disastrous as a rational investment policy in an irrational world.”  Technical analysis provides the only mechanism to measure the “irrational” (emotional) component present in all markets.  In order to drive home the point about the importance of mass psychology, think about what happens when you exchange a piece of page called “money” for some item like food or clothing.  why is that paper, with no intrinsic value, exchanged for something tangible?  It is because of a shared psychology.  Everyone believes it will be accepted so it is.  Once this shared psychology evaporates when people stop believing in money, it becomes worthless.

Second, technical are also an important components of disciplined training.  Discipline helps mitigate the nemesis of all traders, namely, emotion.  As soon as you have money in the market emotionalism is in the driver’s seat and rationale and objectivity are merely passengers.  If you doubt this, try paper trading.  Then try trading with your own funds.  You will soon discover how deeply the counterproductive aspects of tension, anticipation, and anxiety alter the way you trade and view the  markets–usually in proportion to the funds committed.  Technicals can put objectivity back into the driver’s seat.  They provide a mechanism to set entry and exit points, to set risk/reward ratios, or stop out levels.  By using them, you foster a risk and money management approach to trading.  As touched upon in the previous discussion, the technical contribute to market objectivity. It is human nature to see the market as we want to see it, not as it really is.  How often does the following occur?  A trader buys.  Immediately the market falls.  Does he take a loss?  Usually no.   Although there is no room for hope in the market, the trader will glean all the fundamentally bullish news he can in order to buy his hope that the market will turn in his direction (as one of our advisory clients put it, “You root for your position.”)   Meanwhile prices continue to descend. Perhaps the market is trying to tell him something.  The markets communicate with us.  We can monitor these messages by using the Technicals.  This trader is closing his eyes and ears to the messages being sent by the market.  If this trader stepped back and objectively viewed the price activity, he might get a better feel of the market.  What is a supposedly bullish story is released and prices do no move up or even fall? That type of price action is sending out volume of information about the psychology of the market and how one should trade it.  I believe it was the famous trader Jesse Livermore who expressed the idea that one can see the whole better when one see it from a distance.  Technicals make us step back and get a difference and, perhaps, better perspective on the market.

Third, following the Technicals is important even if you do not fully believe in their use.  This is because, at times, the chart actions are the major reason for a market move.  Since they are a market-moving factor, they should be watched.

Fourth, random walk proffers that the market price for one day has no bearing on the price the following day.  But this academic view leaves out an important component–people.  People remember prices from one day to the next and act accordingly.  To wit, people’s reactions indeed affect price, itself, is an important component in market analysis.  Those who disparage technical analysis forget this last point.

Fifth, the price action is the most direct and easily accessible method of seeing overall supply/demand relationships.  There may be fundamental news not knows to the general public, but you can expect it  is already in the price.  Those who have advance knowledge of some market-moving event will most likely buy or sell until current prices reflect their information.”

(From the book of Japanese Candlestick Charting Techniques by Steve Nison pg.11-13)

Analysts & Three Axioms

Market Movement Considers Everything

This is the most important postulate of technical analysis. It is crucial to understand it in order to grasp rightly the procedures of analysis. The gist of it is that any factor that influences the price of securities, whether economic, political, or psychological, has already been taken into account and reflected in the price chart. In other words, every price change is accompanied by a change in external factors. The main inference of this premise is the necessity to follow closely the price movements and analyze them. By means of analyzing price charts and multiple other indicators, a technical analyst comes to the point that the market itself shows to her/him the trend it will most likely follow. This premise is in conflict with fundamental analysis where the attention is primarily paid to the study of factors, and later on, after the analysis of the factors, to conclusions as to the market trends are made. Thus, if the demand is higher than the supply, a fundamental analyst will come to the conclusion that the price will grow. Technical analyst, however, makes her/his conclusions in the opposite sequence: since the price has grown, it means the demand is higher than the supply.
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The Prices Move With the Trend

This assumption is the basis for all methods of technical analysis, as a market that moves in accordance with trends can be analyzed, unlike a chaotic market. The postulate that the price movement is a result of a trend has two effects. The first one implies that the current trend will most likely continue and will not reverse itself, thus, excluding disorderly chaotic movement of the market. The second one implies that the current trend will go on until the opposite trend sets in.

 

The History Repeats Itself

Technical analysis and studies of market dynamics are closely related to the studies of human psychology. Thus, the graphical price models identified and classified within the last hundred years depict core characteristics of the psychological state of the market. First of all, they show the moods currently prevailing in the market, whether bullish or bearish. Since these models worked in the past, we have reasons to suppose that they will work in the future, for they are based on human psychology which remains almost unchaged over years. We can reword the last postulate — the story repeats itself — in a slightly different way: the key to understanding the future lies in the studies of the past.

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