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Technical Analysis

What is Technical Analysis?

Among the various tools financial analysts utilise for forecasting the markets, there are basically two methods: fundamental and technical analysis. The goal of this article is to familiarise you with the technical approach that the financial community, including economists, considers today a valuable alternative or supplement to the fundamental analysis. This is the case despite the fact that TA (technical analysis), which mainly works with a graphical representation of historical price action (called "the chart"), contradicts the weak form of the market efficiency hypothesis saying that historical facts can not be used to forecast the market development. One reason for this positive attitude towards TA might be that various studies issued by the quantitative researcher's community show that serial dependence refused by advocates of the weak form of market efficiency is one of the most reliable observed patterns in the markets (i.e. forex market). Expressed in a simpler language this means that price movements are not a random walk but unfold in trends. This is exactly one of the three premises that TA consists of. The other two are: History repeats itself and market action discounts everything. The former means that certain price formations like triangles, channels, etc. reoccur throughout time and can be used to foresee the extent of an ensuing price move. The latter premise argues that any available information (public as well as inside information) is reflected in the current price. So instead of analysing the economic environment (i.e. monetary and fiscal policy, balance sheet, etc.) a technical analyst bases his or her research exclusively on historical price data. One obvious advantage of this procedure is that the rather decisive psychological rational of the investor is taken into account and included indirectly into the research which is handled mostly through mathematical or geometrical methods. It is crucial to keep in mind that Technical Analysis is not an exact science. Rather, TA rather deals with probability distributions (by the way, the same thing is true for the economic approach!!!) and as such leaves room for unexpected counterproductive outcomes. This means that a strict and rigorous discipline is a must in the practical use of technical analysis which should actually be true for any other approach as well! The advantage of TA in contrast to the fundamental approach is that the decision of maintaining or abandoning an active scenario depends on rather exact criteria that can improve or deteriorate decisively with every single price change. It is not necessary to wait for the outcome of fundamental figures that are already out-of-date at the time of their release!

The techniques applied in TA are manifold. Diverse mathematical computer supported formulas usually try to measure the strength of an underlying price move and to unveil divergences where new price extremes are not confirmed, pre-indicating a potential trend reversal. Usually the main tool of a technical analyst, however, remains the chart. The Elliott wave theory for example (developed in the first half this century) tries to distinguish between impulsive (trending) waves (wave stands for price move) and corrective (counter trending) waves and this "wave count" gives the technical analyst a hint about the future development of the market. Volume is another aspect that is worth noting. Volume figures can tell you an important and decisive story about the flow of money. Candle charts, a graphical "candle-shaped" representation of a trading session's open, high, low, and closing price, are a Japanese invention dating from the 18th century and provide valuable clue about potential reversal or continuation of trends. They illustrate that TA is not a recent discovery (as often assumed) and that TA is not applied by the western hemisphere exclusively.

All in all the different technical theories can be viewed as puzzle stones, the combination of which should lead us to the ultimate goal of TA, the set-up of the highest probability scenario for a specific market direction. The established scenario will not look the same for every technical analyst. This is due to the fact that a different combination and weighting of technical indicators might be applied and that a subjective interpretation of the technical constellation can decisively influence the outcome.

Depending on the context TA can be used in different ways. We want to highlight one approach because of its strenght in portfolio management where benchmarks are used for performance measurements.

As mentioned above, we are well aware of the fact that TA deals with probabilities and there are times when the probability distribution is especially favourable and shows a specific scenario. These are the situations when a deviation from the benchmark should be seriously considered as one has the best technical starting point for potential outperformance. The corresponding risk is minimised through the application of a near but technically justifiable protective stop-loss.

By starting to promote technical analysis, even well known Universities now send the financial world the signal that TA, as an original approach to the market forecasting dilemma, has become an important and respected tool in professional portfolio management. Last but not least let's mention the following statements from central bankers that might convince any remaining sceptics:

"Technical analysis, the prediction of price movements based on past price movements, has been shown to generate statistically significant profits despite its incompatibility with most economists' notions of efficient markets..." Federal Reserve Bank of New York, C.L. Osler and P.H. Kevin Chang, Staff Report No. 4, August 1995.

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15.07.2013
Economics 101