The discipline of technical analysis is unconcerned with fundamental measures of valuation.
In a shopping centre, a fundamental analyst would go to each shop, study the product that was being sold, and then decide whether to buy it or not. By contrast, a technical analyst would sit on a bench in the shopping centre and watch people go into the shops. Disregarding the intrinsic value of the products in the shops, his or her decision would be based on the patterns or activity of people going into each one.
Technical analysis is applicable to stocks, indices, commodities, futures or any tradeable instrument where the price is influenced by the forces of supply and demand. Price refers to any combination of the open, high, low or close for a given security over a specific time frame. The time frame can be based on intraday, daily, weekly or monthly price data and last a few hours or many years. In addition, some technical analysts include volume or open interest figures with their study of price action.
Technical analysis holds that because every possible bit of information is included in a security's price, it is not necessary to explicitly analyse the fundamental, economic, political, etc. factors that might influence that price. Because all available information is already included in the current price, only a study of the price movement is required.
The last traded price is the end result of the battle between the forces of supply and demand for the instrument. It represents a temporary consensus of value between two participants. The objective of analysis is to forecast the direction of the future price. By focusing on price and only price, technical analysis represents a direct approach. Fundamental analysts are concerned with "why" the price is where it is. For technicians, the "why" portion of the equation is too broad and many times the fundamental reasons given are highly suspect. Technicians believe it is best to concentrate on "what" and never mind "why". Why did the price go up? It is simple, more buyers (demand) than sellers (supply). After all, the value of any asset is only what someone is willing to pay for it. Who needs to know why?
While it is not explicitly proven that prices must trend, technical analysis relies on empirical evidence and simple common sense to assert that prices do repeatedly form identifiable trends.
Technical analysts believe that human psychology, especially in regard to crowd behaviour, can help determine likely future price movement. The market might be irrational but nonetheless it is composed of humans who will repeat, or at least "echo", their behaviour time and time again under certain conditions, probably due to the inbuilt "fight or flight" response that can disable rational thought and provoke imprudent, panic trading descisions. Because traders' attitudes repeat, their actions as determined by price movement will repeat. i.e., price patterns will develop on a chart that a technical analyst believes have predictive qualities. Thus technical analysis also posits that price movements are not random.
Just as with fundamental analysis, technical analysis is subjective and our personal biases can be reflected in the analysis.
Furthering the bias argument is the fact that technical analysis is open to interpretation. Even though there are standards, many times two technicians will look at the same chart and paint two different scenarios or see different chart patterns. Both will be able to come up with logical support and resistance levels as well as key breaks to justify their position. While this can be frustrating, it should be pointed out that technical analysis perches awkwardly between art and science, somewhat like economics. Is the cup half-empty or half-full? It is in the eye of the beholder.
Technical analysis has been criticized for being too late. By the time the trend is identified, a substantial portion of the move has already taken place. After such a large move, the reward to risk ratio is not great. Lateness is a particular criticism of Dow Theory.
Even after a new trend has been identified, there is always another "important" level close at hand. Technicians have been accused of sitting on the fence and never taking an unqualified stance. Even if they are bullish, there is always some indicator or some level that will qualify their opinion.
Not all technical signals and patterns work. When you begin to study technical analysis, you will come across an array of patterns and indicators with rules to match. For instance: A sell signal is given when the neckline of a head and shoulders pattern is broken. Even though this is a rule, it is not steadfast and can be subject to other factors such as volume and momentum. In that same vein, what works for one particular stock may not work for another. A 50-day moving average may work great to identify support and resistance for IBM, but a 70-day moving average may work better for Yahoo. Even though many principles of technical analysis are universal, each security will have its own idiosyncrasies.
Some claim that because the price patterns of technical analysis are widely disseminated throughout the investment community and that traders are so familiar with them, technicians act on them together unknowingly. These bursts of buying and selling appear to give credence to the predictive claims of the patterns when no such predictive quality exists.
Technical analysts counter that if it were the case that they were acting in concert with each other, the same signals that told them all to buy would tell them all to sell. That is to say, none of them would make any money trading. Since this is not the case, they claim, technical analysis principles are not self-fulfilling.
Technical analysts also point out that pattern recognition is somewhat subjective so it would be impossible for their entire community to act as one.
Critics say that technical analysis's reliance on past price data is not grounded in any scientific discipline and therefore has no bearing on future price movements. Proponents of technical analysis claim that any descriptive statistical analysis relies upon prior price data to generate predictions or likely outcomes. Some go so far as to say that technical analysis is merely a type of time series analysis.
Pure fundamental analysts are typically the staunchest critics of technical analysis as they believe that the only correct way to determine a security's price is through the analysis of the security's finances, something which technical analysis says is not necessary to examine.
Common technical patterns and indicators
(What are Candlesticks?)
Price pattern theories
(What is a Technical indicator?)
(What is a Market Indicator?)
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