In
finance"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
,
technical analysis is
security analysisSecurity analysis is the analysis of tradeable financial instruments called securities. These can be classified into debt securities, equities, or some hybrid of the two. More broadly, futures contracts and tradeable credit derivatives are sometimes included...
discipline for forecasting the direction of prices through the study of past market data, primarily price and volume. Behavioral economics and quantitative analysis incorporate technical analysis, which being an aspect of
active managementActive management refers to a portfolio management strategy where the manager makes specific investments with the goal of outperforming an investment benchmark index...
stands in contradiction to much of
modern portfolio theoryModern portfolio theory is a theory of investment which attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets...
. The efficacy of both technical and
fundamental analysisFundamental analysis of a business involves analyzing its financial statements and health, its management and competitive advantages, and its competitors and markets. When applied to futures and forex, it focuses on the overall state of the economy, interest rates, production, earnings, and...
is disputed by efficient-market hypothesis which states that stock market prices are essentially unpredictable.
History
The principles of technical analysis are derived from hundreds of years of
financial marketIn economics, a financial market is a mechanism that allows people and entities to buy and sell financial securities , commodities , and other fungible items of value at low transaction costs and at prices that reflect supply and demand.Both general markets and...
data. Some aspects of technical analysis began to appear in Joseph de la Vega's accounts of the Dutch markets in the 17th century. In Asia, technical analysis is said to be a method developed by
Homma Munehisa, was a rice merchant from Sakata, Japan who traded in the Ojima Rice market in Osaka during the Tokugawa Shogunate...
during early 18th century which evolved into the use of
candlestick techniquesA candlestick chart is a style of bar-chart used primarily to describe price movements of a security, derivative, or currency over time.It is a combination of a line-chart and a bar-chart, in that each bar represents the range of price movement over a given time interval. It is most often used in...
, and is today a technical analysis charting tool. In the 1920s and 1930s Richard W. Schabacker published several books which continued the work of
Charles DowCharles Henry Dow was an American journalist who co-founded Dow Jones & Company with Edward Jones and Charles Bergstresser....
and
William Peter HamiltonWilliam Peter Hamilton was the fourth editor of the Wall Street Journal and a proponent of Dow Theory.-Publications:* with Charles Henry Dow -References:...
in their books
Stock Market Theory and Practice and
Technical Market Analysis. In 1948 Robert D. Edwards and John Magee published
Technical Analysis of Stock Trends which is widely considered to be one of the seminal works of the discipline. It is exclusively concerned with trend analysis and chart patterns and remains in use to the present. As is obvious, early technical analysis was almost exclusively the analysis of charts, because the processing power of computers was not available for statistical analysis. Charles Dow reportedly originated a form of
point and figure chartPoint and figure is a charting technique used in technical analysis, used to attempt to predict financial market prices. Point and figure charting is unique in that it does not plot price against time as all other techniques do...
analysis.
Dow TheoryThe Dow theory on stock price movement is a form of technical analysis that includes some aspects of sector rotation. The theory was derived from 255 Wall Street Journal editorials written by Charles H. Dow , journalist, founder and first editor of the Wall Street Journal and co-founder of Dow...
is based on the collected writings of Dow Jones co-founder and editor Charles Dow, and inspired the use and development of modern technical analysis at the end of the 19th century. Other pioneers of analysis techniques include
Ralph Nelson ElliottRalph Nelson Elliott was an American accountant and author, whose study of stock market data led him to develop the Wave Principle, a form of technical analysis that identifies trends in the financial markets...
,
William Delbert GannWilliam Delbert Gann or WD Gann, was a finance trader who developed the technical analysis tools known as Gann angles, Square of 9, Hexagon, Circle of 360 . Gann market forecasting methods are based on geometry, astronomy and astrology, and ancient mathematics...
and
Richard WyckoffRichard Demille Wyckoff was a stock market authority, founder and onetime editor of the Magazine of Wall Street , and editor of Stock Market Technique.-Research and teachings:...
who developed their respective techniques in the early 20th century. More technical tools and theories have been developed and enhanced in recent decades, with an increasing emphasis on computer-assisted techniques using specially designed computer software.
General description
While fundamental analysts examine earnings, dividends, new products, research and the like, technical analysts examine what investors fear or think about those developments and whether or not investors have the wherewithal to back up their opinions; these two concepts are called psych (psychology) and supply/demand. Technicians employ many techniques, one of which is the use of charts. Using charts, technical analysts seek to identify price patterns and
market trendA market trend is a putative tendency of a financial market to move in a particular direction over time. These trends are classified as secular for long time frames, primary for medium time frames, and secondary for short time frames...
s in financial markets and attempt to exploit those patterns. Technicians use various methods and tools, the study of price charts is but one.
Technicians using charts search for archetypal price chart patterns, such as the well-known
head and shouldersThe Head and Shoulders formation is one of the most well known reversal patterns.On the technical analysis chart, when a price trend is in the process of reversal either from a bullish or bearish trend, a characteristic pattern takes shape and is recognized as reversal formation.-Head and shoulders...
or double top/bottom reversal patterns, study technical indicators, moving averages, and look for forms such as lines of support, resistance, channels, and more obscure formations such as flags, pennants, balance days and
cup and handleThe cup and handle formation is a bullish chart pattern that is defined by a chart where a stock drops in value, then rises back up to the original value, then drops a small amount in value, and then rises a small amount in value...
patterns.
Technical analysts also widely use market indicators of many sorts, some of which are mathematical transformations of price, often including up and down volume, advance/decline data and other inputs. These indicators are used to help assess whether an asset is trending, and if it is, the probability of its direction and of continuation. Technicians also look for relationships between price/volume indices and market indicators. Examples include the
relative strength indexThe Relative Strength Index is a technical indicator used in the technical analysis of financial markets. It is intended to chart the current and historical strength or weakness of a stock or market based on the closing prices of a recent trading period...
, and
MACDMACD is a technical analysis indicator created by Gerald Appel in the late 1970s. It is used to spot changes in the strength, direction, momentum, and duration of a trend in a stock's price....
. Other avenues of study include correlations between changes in
optionIn finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
s (
implied volatilityIn financial mathematics, the implied volatility of an option contract is the volatility of the price of the underlying security that is implied by the market price of the option based on an option pricing model. In other words, it is the volatility that, when used in a particular pricing model,...
) and put/call ratios with price. Also important are sentiment indicators such as Put/Call ratios, bull/bear ratios, short interest, Implied Volatility, etc.
There are many techniques in technical analysis. Adherents of different techniques (for example,
candlestick chartA candlestick chart is a style of bar-chart used primarily to describe price movements of a security, derivative, or currency over time.It is a combination of a line-chart and a bar-chart, in that each bar represents the range of price movement over a given time interval. It is most often used in...
ing,
Dow TheoryThe Dow theory on stock price movement is a form of technical analysis that includes some aspects of sector rotation. The theory was derived from 255 Wall Street Journal editorials written by Charles H. Dow , journalist, founder and first editor of the Wall Street Journal and co-founder of Dow...
, and Elliott wave theory) may ignore the other approaches, yet many
tradersA trader is someone in finance who buys and sells financial instruments such as stocks, bonds, commodities and derivatives. A broker who simply fills buy or sell orders is not a trader, as they are merely executing instructions given to them. According to the Wall Street Journal in 2004, a managing...
combine elements from more than one technique. Some technical analysts use subjective judgment to decide which pattern(s) a particular instrument reflects at a given time and what the interpretation of that pattern should be. Others employ a strictly mechanical or systematic approach to pattern identification and interpretation.
Technical analysis is frequently contrasted with
fundamental analysisFundamental analysis of a business involves analyzing its financial statements and health, its management and competitive advantages, and its competitors and markets. When applied to futures and forex, it focuses on the overall state of the economy, interest rates, production, earnings, and...
, the study of economic factors that influence the way investors price financial markets. Technical analysis holds that prices already reflect all such trends before investors are aware of them. Uncovering those trends is what technical indicators are designed to do, imperfect as they may be. Fundamental indicators are subject to the same limitations, naturally. Some traders use technical or fundamental analysis exclusively, while others use both types to make trading decisions.
Characteristics
Technical analysis employs models and trading rules based on price and volume transformations, such as the
relative strength indexThe Relative Strength Index is a technical indicator used in the technical analysis of financial markets. It is intended to chart the current and historical strength or weakness of a stock or market based on the closing prices of a recent trading period...
, moving averages,
regressionIn statistics, regression analysis includes many techniques for modeling and analyzing several variables, when the focus is on the relationship between a dependent variable and one or more independent variables...
s, inter-market and intra-market price correlations,
business cycleThe term business cycle refers to economy-wide fluctuations in production or economic activity over several months or years...
s,
stock market cyclesStock market cycles are the long-term price patterns of the stock market.-Description:There are many types of business cycles including those that impact the stock market....
or, classically, through recognition of chart patterns.
Technical analysis stands in contrast to the
fundamental analysisFundamental analysis of a business involves analyzing its financial statements and health, its management and competitive advantages, and its competitors and markets. When applied to futures and forex, it focuses on the overall state of the economy, interest rates, production, earnings, and...
approach to security and stock analysis. Technical analysis analyzes price, volume and other market information, whereas fundamental analysis looks at the facts of the company, market, currency or commodity. Most large brokerage, trading group, or financial institutions will typically have both a technical analysis and fundamental analysis team.
Technical analysis is widely used among traders and financial professionals and is very often used by active
day traderA day trader is a trader who buys and sells financial instruments within the same trading day such that all positions will usually be closed before the market close of the trading day. This trading style is called day trading...
s, market makers and pit traders. In the 1960s and 1970s it was widely dismissed by academics. In a recent review, Irwin and Park reported that 56 of 95 modern studies found that it produces positive results but noted that many of the positive results were rendered dubious by issues such as data snooping, so that the evidence in support of technical analysis was inconclusive; it is still considered by many academics to be
pseudosciencePseudoscience is a claim, belief, or practice which is presented as scientific, but which does not adhere to a valid scientific method, lacks supporting evidence or plausibility, cannot be reliably tested, or otherwise lacks scientific status...
. Academics such as
Eugene FamaEugene Francis "Gene" Fama is an American economist, known for his work on portfolio theory and asset pricing, both theoretical and empirical. He is currently Robert R...
say the evidence for technical analysis is sparse and is inconsistent with the
weak form of the efficient-market hypothesis. Users hold that even if technical analysis cannot predict the future, it helps to identify trading opportunities.
In the
foreign exchange marketThe foreign exchange market is a global, worldwide decentralized financial market for trading currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends...
s, its use may be more widespread than
fundamental analysisFundamental analysis of a business involves analyzing its financial statements and health, its management and competitive advantages, and its competitors and markets. When applied to futures and forex, it focuses on the overall state of the economy, interest rates, production, earnings, and...
. This does not mean technical analysis is more applicable to foreign markets, but that technical analysis is more recognized as to its efficacy there than elsewhere.
While some isolated studies have indicated that technical trading rules might lead to consistent returns in the period prior to 1987, most academic work has focused on the nature of the anomalous position of the foreign exchange market. It is speculated that this anomaly is due to central bank intervention, which obviously technical analysis is not designed to predict. Recent research suggests that combining various trading signals into a Combined Signal Approach may be able to increase profitability and reduce dependence on any single rule.
Principles
A fundamental principle of technical analysis is that a market's price reflects all relevant information, so their analysis looks at the history of a security's trading pattern rather than external drivers such as economic, fundamental and news events. Price action also tends to repeat itself because investors collectively tend toward patterned behavior – hence technicians' focus on identifiable trends and conditions.
Market action discounts everything
Based on the premise that all relevant information is already reflected by prices, technical analysts believe it is important to understand what investors think of that information, known and perceived.
Prices move in trends
Technical analysts believe that prices trend directionally, i.e., up, down, or sideways (flat) or some combination. The basic definition of a price trend was originally put forward by
Dow TheoryThe Dow theory on stock price movement is a form of technical analysis that includes some aspects of sector rotation. The theory was derived from 255 Wall Street Journal editorials written by Charles H. Dow , journalist, founder and first editor of the Wall Street Journal and co-founder of Dow...
.
An example of a security that had an apparent trend is AOL from November 2001 through August 2002. A technical analyst or trend follower recognizing this trend would look for opportunities to sell this security. AOL consistently moves downward in price. Each time the stock rose, sellers would enter the market and sell the stock; hence the "zig-zag" movement in the price. The series of "lower highs" and "lower lows" is a tell tale sign of a stock in a down trend. In other words, each time the stock moved lower, it fell below its previous relative low price. Each time the stock moved higher, it could not reach the level of its previous relative high price.
Note that the sequence of lower lows and lower highs did not begin until August. Then AOL makes a low price that does not pierce the relative low set earlier in the month. Later in the same month, the stock makes a relative high equal to the most recent relative high. In this a technician sees strong indications that the down trend is at least pausing and possibly ending, and would likely stop actively selling the stock at that point.
History tends to repeat itself
Technical analysts believe that investors collectively repeat the behavior of the investors that preceded them. To a technician, the emotions in the market may be irrational, but they exist. Because investor behavior repeats itself so often, technicians believe that recognizable (and predictable) price patterns will develop on a chart.
Technical analysis is not limited to charting, but it always considers price trends. For example, many technicians monitor surveys of investor sentiment. These surveys gauge the attitude of market participants, specifically whether they are bearish or bullish. Technicians use these surveys to help determine whether a trend will continue or if a reversal could develop; they are most likely to anticipate a change when the surveys report extreme investor sentiment Surveys that show overwhelming bullishness, for example, are evidence that an uptrend may reverse; the premise being that if most investors are bullish they have already bought the market (anticipating higher prices). And because most investors
are bullish and invested, one assumes that few buyers remain. This leaves more potential sellers than buyers, despite the bullish sentiment. This suggests that prices will trend down, and is an example of
contrarian tradingIn finance, a contrarian is one who attempts to profit by investing in a manner that differs from the conventional wisdom, when the consensus opinion appears to be wrong....
.
Recently, Kim Man Lui, Lun Hu, and Keith C.C. Chan have suggested that there is statistical evidence of association relationships between some of the index composite stocks whereas there is no evidence for such a relationship between some index composite others. They show that the price behavior of these Hang Seng index composite stocks is easier to understand than that of the index.
Industry
The industry is globally represented by the International Federation of Technical Analysts (IFTA), which is a Federation of regional and national organizations. In the United States, the industry is represented by both the
Market Technicians AssociationThe Market Technicians Association is a non-profit, global, professional organization of Technical Analysts based out of New York City. The MTA seeks to educate the financial community and public, increase the use of Technical Analysis, and maintain standards of expertise and ethics among...
(MTA) and the American Association of Professional Technical Analysts (AAPTA). The United States is also represented by the Technical Security Analysts Association of San Francisco (TSAASF). In the United Kingdom, the industry is represented by the Society of Technical Analysts (STA). In Canada the industry is represented by the Canadian Society of Technical Analysts. In Australia, the industry is represented by the Australian Professional Technical Analysts (APTA) Inc and the Australian Technical Analysts Association (ATAA).
Professional technical analysis societies have worked on creating a body of knowledge that describes the field of Technical Analysis. A body of knowledge is central to the field as a way of defining how and why technical analysis may work. It can then be used by academia, as well as regulatory bodies, in developing proper research and standards for the field. The
Market Technicians AssociationThe Market Technicians Association is a non-profit, global, professional organization of Technical Analysts based out of New York City. The MTA seeks to educate the financial community and public, increase the use of Technical Analysis, and maintain standards of expertise and ethics among...
(MTA) has published a body of knowledge, which is the structure for the MTA's
Chartered Market TechnicianChartered Market Technician is a professional designation that confirms proficiency in technical analysis of the financial markets. To hold the designation, membership in the Market Technicians Association is required....
(CMT) exam.
Neural networks
Since the early 1990s when the first practically usable types emerged,
artificial neural networkAn artificial neural network , usually called neural network , is a mathematical model or computational model that is inspired by the structure and/or functional aspects of biological neural networks. A neural network consists of an interconnected group of artificial neurons, and it processes...
s (ANNs) have rapidly grown in popularity. They are
artificial intelligenceArtificial intelligence is the intelligence of machines and the branch of computer science that aims to create it. AI textbooks define the field as "the study and design of intelligent agents" where an intelligent agent is a system that perceives its environment and takes actions that maximize its...
adaptive software systems that have been inspired by how biological neural networks work. They are used because they can learn to detect complex patterns in data. In mathematical terms, they are universal
function approximatorsThe need for function approximations arises in many branches of applied mathematics, and computer science in particular. In general, a function approximation problem asks us to select a function among a well-defined class that closely matches a target function in a task-specific way.One can...
, meaning that given the right data and configured correctly, they can capture and model any input-output relationships. This not only removes the need for human interpretation of charts or the series of rules for generating entry/exit signals, but also provides a bridge to
fundamental analysisFundamental analysis of a business involves analyzing its financial statements and health, its management and competitive advantages, and its competitors and markets. When applied to futures and forex, it focuses on the overall state of the economy, interest rates, production, earnings, and...
, as the variables used in fundamental analysis can be used as input.
As ANNs are essentially non-linear statistical models, their accuracy and prediction capabilities can be both mathematically and empirically tested. In various studies, authors have claimed that neural networks used for generating trading signals given various technical and fundamental inputs have significantly outperformed buy-hold strategies as well as traditional linear technical analysis methods when combined with rule-based expert systems.
While the advanced mathematical nature of such adaptive systems has kept neural networks for financial analysis mostly within academic research circles, in recent years more user friendly
neural network softwareNeural network software is used to simulate, research, develop and apply artificial neural networks, biological neural networks and in some cases a wider array of adaptive systems.-Simulators:...
has made the technology more accessible to traders. However, large-scale application is problematic because of the problem of matching the correct neural topology to the market being studied.
Combination with other market forecast methods
John MurphyJohn J. Murphy is an American financial market analyst, and is considered the father of inter-market technical analysis He has authored several books, but is most known for his book, Technical Analysis of the Futures Markets...
states that the principal sources of information available to technicians are price, volume and
open interestOpen interest refers to the total number of derivative contracts, like futures and options, that have not been settled in the immediately previous time period for a specific underlying security...
. Other data, such as indicators and
sentiment analysisSentiment analysis or opinion mining refers to the application of natural language processing, computational linguistics, and text analytics to identify and extract subjective information in source materials....
, are considered secondary.
However, many technical analysts reach outside pure technical analysis, combining other market forecast methods with their technical work. One advocate for this approach is
John BollingerJohn A. Bollinger is an American author, financial analyst, contributor to the field of technical analysis and the developer of Bollinger Bands. His book Bollinger on Bollinger Bands, John Bollinger, McGraw Hill, 2002, ISBN 978-0-07-137368-5, has been translated into eight languages.Chinese ,...
, who coined the term
rational analysis in the middle 1980s for the intersection of technical analysis and fundamental analysis. Another such approach, fusion analysis, overlays fundamental analysis with technical, in an attempt to improve portfolio manager performance.
Technical analysis is also often combined with
quantitative analysisA quantitative analyst is a person who works in finance using numerical or quantitative techniques. Similar work is done in most other modern industries, but the work is not always called quantitative analysis...
and
economicsEconomics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
. For example, neural networks may be used to help identify intermarket relationships. A few market forecasters combine
financial astrologyFinancial astrology is the practice of relating the movements of celestial bodies to events in financial markets...
with technical analysis. Chris Carolan's article "Autumn Panics and Calendar Phenomenon", which won the Market Technicians Association Dow Award for best technical analysis paper in 1998, demonstrates how technical analysis and lunar cycles can be combined. Calendar phenomena, such as the
January effectThe January effect is a calendar-related anomaly in the financial market where financial security prices increase in the month of January. This creates an opportunity for investors to buy stock for lower prices before January and sell them after their value increases.Therefore, the main...
in the stock market, are generally believed to be caused by tax and accounting related transactions, and are not related to the subject of
financial astrologyFinancial astrology is the practice of relating the movements of celestial bodies to events in financial markets...
.
Investor and newsletter polls, and magazine cover sentiment indicators, are also used by technical analysts.
Empirical evidence
Whether technical analysis actually works is a matter of controversy. Methods vary greatly, and different technical analysts can sometimes make contradictory predictions from the same data. Many investors claim that they experience positive returns, but academic appraisals often find that it has little
predictive powerThe predictive power of a scientific theory refers to its ability to generate testable predictions. Theories with strong predictive power are highly valued, because the predictions can often encourage the falsification of the theory...
. Of 95 modern studies, 56 concluded that technical analysis had positive results, although data-snooping bias and other problems make the analysis difficult. Nonlinear prediction using
neural networksAn artificial neural network , usually called neural network , is a mathematical model or computational model that is inspired by the structure and/or functional aspects of biological neural networks. A neural network consists of an interconnected group of artificial neurons, and it processes...
occasionally produces
statistically significantIn statistics, a result is called statistically significant if it is unlikely to have occurred by chance. The phrase test of significance was coined by Ronald Fisher....
prediction results. A Federal Reserve working paper regarding support and resistance levels in short-term foreign exchange rates "offers strong evidence that the levels help to predict intraday trend interruptions," although the "predictive power" of those levels was "found to vary across the exchange rates and firms examined".
Technical trading strategies were found to be effective in the Chinese marketplace by a recent study that states, "Finally, we find significant positive returns on buy trades generated by the contrarian version of the moving-average crossover rule, the channel breakout rule, and the Bollinger band trading rule, after accounting for transaction costs of 0.50 percent."
An influential 1992 study by Brock et al. which appeared to find support for technical trading rules was tested for data snooping and other problems in 1999; the sample covered by Brock et al. was robust to data snooping.
Subsequently, a comprehensive study of the question by Amsterdam economist Gerwin Griffioen concludes that: "for the U.S., Japanese and most Western European stock market indices the recursive out-of-sample forecasting procedure does not show to be profitable, after implementing little transaction costs. Moreover, for sufficiently high transaction costs it is found, by estimating
CAPMIn finance, the capital asset pricing model is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk...
s, that technical trading shows no statistically significant risk-corrected out-of-sample forecasting power for almost all of the stock market indices." Transaction costs are particularly applicable to "momentum strategies"; a comprehensive 1996 review of the data and studies concluded that even small transaction costs would lead to an inability to capture any excess from such strategies.
In a paper published in the
Journal of FinanceThe Journal of Finance is a peer-reviewed academic journal published by Wiley-Blackwell on behalf of the American Finance Association. It was established in 1946. Its current editors are Campbell R. Harvey and John R. Graham...
, Dr. Andrew W. Lo, director MIT Laboratory for Financial Engineering, working with Harry Mamaysky and Jiang Wang found that "
In that same paper Dr. Lo wrote that "several academic studies suggest that ... technical analysis may well be an effective means for extracting useful information from market prices." Some techniques such as
Drummond Geometry Drummond Geometry is a trading method consisting of a series of technical analysis tools invented by the Canadian trader Charles Drummond starting in the 1970s and continuing to the present...
attempt to overcome the past data bias by projecting support and resistance levels from differing time frames into the near-term future and combining that with reversion to the mean techniques.
Efficient market hypothesis
The efficient-market hypothesis (EMH) contradicts the basic tenets of technical analysis by stating that past prices cannot be used to profitably predict future prices. Thus it holds that technical analysis cannot be effective. Economist
Eugene FamaEugene Francis "Gene" Fama is an American economist, known for his work on portfolio theory and asset pricing, both theoretical and empirical. He is currently Robert R...
published the seminal paper on the EMH in the
Journal of Finance in 1970, and said "In short, the evidence in support of the efficient markets model is extensive, and (somewhat uniquely in economics) contradictory evidence is sparse."
Technicians say that EMH ignores the way markets work, in that many investors base their expectations on past earnings or track record, for example. Because future stock prices can be strongly influenced by investor expectations, technicians claim it only follows that past prices influence future prices. They also point to research in the field of
behavioral financeBehavioral economics and its related area of study, behavioral finance, use social, cognitive and emotional factors in understanding the economic decisions of individuals and institutions performing economic functions, including consumers, borrowers and investors, and their effects on market...
, specifically that people are not the rational participants EMH makes them out to be. Technicians have long said that irrational human behavior influences stock prices, and that this behavior leads to predictable outcomes. Author David Aronson says that the theory of behavioral finance blends with the practice of technical analysis:
By considering the impact of emotions, cognitive errors, irrational preferences, and the dynamics of group behavior, behavioral finance offers succinct explanations of excess market volatility as well as the excess returns earned by stale information strategies.... cognitive errors may also explain the existence of market inefficiencies that spawn the systematic price movements that allow objective TA [technical analysis] methods to work.
EMH advocates reply that while individual market participants do not always act rationally (or have complete information), their aggregate decisions balance each other, resulting in a rational outcome (optimists who buy stock and bid the price higher are countered by pessimists who sell their stock, which keeps the price in equilibrium). Likewise, complete information is reflected in the price because all market participants bring their own individual, but incomplete, knowledge together in the market.
Random walk hypothesis
The
random walk hypothesisThe random walk hypothesis is a financial theory stating that stock market prices evolve according to a random walk and thus the prices of the stock market cannot be predicted. It is consistent with the efficient-market hypothesis....
may be derived from the weak-form efficient markets hypothesis, which is based on the assumption that market participants take full account of any information contained in past price movements (but not necessarily other public information). In his book
A Random Walk Down Wall Street, Princeton economist
Burton MalkielBurton Gordon Malkiel is an American economist and writer, most famous for his classic finance book A Random Walk Down Wall Street...
said that technical forecasting tools such as pattern analysis must ultimately be self-defeating: "The problem is that once such a regularity is known to market participants, people will act in such a way that prevents it from happening in the future." Malkiel has stated that while momentum may explain some stock price movements, there is not enough momentum to make excess profits. Malkiel has compared technical analysis to "
astrologyAstrology consists of a number of belief systems which hold that there is a relationship between astronomical phenomena and events in the human world...
".
In the late 1980s, professors Andrew Lo and Craig McKinlay published a paper which cast doubt on the random walk hypothesis. In a 1999 response to Malkiel, Lo and McKinlay collected empirical papers that questioned the hypothesis' applicability that suggested a non-random and possibly predictive component to stock price movement, though they were careful to point out that rejecting random walk does not necessarily invalidate EMH, which is an entirely separate concept from RWH. In a 2000 paper,
Andrew LoAndrew W. Lo is the Harris & Harris Group Professor of Finance at the MIT Sloan School of Management. He is a leading authority on hedge funds and financial engineering; he proposed the Adaptive market hypothesis...
back-analyzed data from U.S. from 1962 to 1996 and found that "several technical indicators do provide incremental information and may have some practical value". Burton Malkiel dismissed the irregularities mentioned by Lo and McKinlay as being too small to profit from.
Technicians say that the EMH and random walk theories both ignore the realities of markets, in that participants are not completely rational and that current price moves are not independent of previous moves. Some signal processing researchers negate the random walk hypothesis that stock market prices resemble
Wiener processesIn mathematics, the Wiener process is a continuous-time stochastic process named in honor of Norbert Wiener. It is often called standard Brownian motion, after Robert Brown...
, because the statistical moments of such processes and real stock data vary significantly with respect window size and similarity measure. They argue that feature transformations used for the description of audio and biosignals can also be used to predict stock market prices successfully which would contradict the random walk hypothesis.
The random walk index (RWI) is a technical indicator that attempts to determine if a stock’s price movement is random or nature or a result of a statistically significant trend. The random walk index attempts to determine when the market is in a strong uptrend or downtrend by measuring price ranges over N and how it differs from what would be expected by a random walk (randomly going up or down). The greater the range suggests a stronger trend.
Concepts
- Resistance — a price level that may prompt a net increase of selling activity
- Support
Support and resistance is a concept in technical analysis that the movement of the price of a security will tend to stop and reverse at certain predetermined price levels.- Support :...
— a price level that may prompt a net increase of buying activity
- Breakout
A breakout is when prices pass through and stay through an area of support or resistance. On the technical analysis chart a break out occurs when price of a stock or commodity exits an area pattern....
— the concept whereby prices forcefully penetrate an area of prior supportSupport and resistance is a concept in technical analysis that the movement of the price of a security will tend to stop and reverse at certain predetermined price levels.- Support :...
or resistance, usually, but not always, accompanied by an increase in volume.
- Trending
A market trend is a putative tendency of a financial market to move in a particular direction over time. These trends are classified as secular for long time frames, primary for medium time frames, and secondary for short time frames...
— the phenomenon by which price movement tends to persist in one direction for an extended period of time
- Average true range
Average True Range is a technical analysis volatility indicator originally developed by J. Welles Wilder, Jr. for commodities. The indicator does not provide an indication of price trend, simply the degree of price volatility....
— averaged daily trading range, adjusted for price gaps
- Chart pattern — distinctive pattern created by the movement of security prices on a chart
- Dead cat bounce
In economics, a dead cat bounce is a small, brief recovery in the price of a declining stock. Derived from the idea that "even a dead cat will bounce if it falls from a great height", the phrase, which originated on Wall Street, is also popularly used to any case where a subject experiences a brief...
— the phenomenon whereby a spectacular decline in the price of a stock is immediately followed by a moderate and temporary rise before resuming its downward movement
- Elliott wave principle
The Elliott Wave Principle is a form of technical analysis that some traders use to analyze financial market cycles and forecast market trends by identifying extremes in investor psychology, highs and lows in prices, and other collective factors...
and the golden ratioIn mathematics and the arts, two quantities are in the golden ratio if the ratio of the sum of the quantities to the larger quantity is equal to the ratio of the larger quantity to the smaller one. The golden ratio is an irrational mathematical constant, approximately 1.61803398874989...
to calculate successive price movements and retracements
- Fibonacci ratios — used as a guide to determine support and resistance
- Momentum
Momentum and rate of change are simple technical analysis indicators showing the difference between today's closing price and the close N days ago. Momentum is the absolute difference in stock, commodity:...
— the rate of price change
- Point and figure analysis
Point and figure is a charting technique used in technical analysis, used to attempt to predict financial market prices. Point and figure charting is unique in that it does not plot price against time as all other techniques do...
— A priced-based analytical approach employing numerical filters which may incorporate time references, though ignores time entirely in its construction.
- Cycles
Stock market cycles are the long-term price patterns of the stock market.-Description:There are many types of business cycles including those that impact the stock market....
— time targets for potential change in price action (price only moves up, down, or sideways)
Types of charts
- Open-high-low-close chart
An open-high-low-close chart is a type of chart typically used to illustrate movements in the price of a financial instrument over time. Each vertical line on the chart shows the price range over one unit of time, e.g. one day or one hour...
— OHLC charts, also known as bar charts, plot the span between the high and low prices of a trading period as a vertical line segment at the trading time, and the open and close prices with horizontal tick marks on the range line, usually a tick to the left for the open price and a tick to the right for the closing price.
- Candlestick chart
A candlestick chart is a style of bar-chart used primarily to describe price movements of a security, derivative, or currency over time.It is a combination of a line-chart and a bar-chart, in that each bar represents the range of price movement over a given time interval. It is most often used in...
— Of Japanese origin and similar to OHLC, candlesticks widen and fill the interval between the open and close prices to emphasize the open/close relationship. In the West, often black or red candle bodies represent a close lower than the open, while white, green or blue candles represent a close higher than the open price.
- Line chart
A line chart or line graph is a type of graph, which displays information as a series of data points connected by straight line segments. It is a basic type of chart common in many fields. It is an extension of a scatter graph, and is created by connecting a series of points that represent...
— Connects the closing price values with line segments.
- Point and figure chart
Point and figure is a charting technique used in technical analysis, used to attempt to predict financial market prices. Point and figure charting is unique in that it does not plot price against time as all other techniques do...
— a chart type employing numerical filters with only passing references to time, and which ignores time entirely in its construction.
Overlays
Overlays are generally superimposed over the main price chart.
- Resistance — a price level that may act as a ceiling above price
- Support
Support and resistance is a concept in technical analysis that the movement of the price of a security will tend to stop and reverse at certain predetermined price levels.- Support :...
— a price level that may act as a floor below price
- Trend line
A trend line is formed when you can draw a diagonal line between two or more price pivot points. They are commonly used to judge entry and exit investment timing when trading securities. It can also be referred to a dutch line as it was first used in Holland.A trend line is a bounding line for the...
— a sloping line described by at least two peaks or two troughs
- Channel
A price channel is a pair of parallel trend lines that form a chart pattern for a stock or commodity. Channels may be horizontal, ascending or descending. When prices pass through and stay through a trendline representing support or resistance, the trend is said to be broken and there is a...
— a pair of parallel trend lines
- Moving average — the last n-bars of price divided by "n" -- where "n" is the number of bars specified by the length of the average. A moving average can be thought of as a kind of dynamic trend-line.
- Bollinger bands
Bollinger Bands and the related indicators %b and BandWidth are technical analysis tools invented by John Bollinger in the 1980s. Having evolved from the concept of trading bands, Bollinger Bands can be used to measure the highness or lowness of the price relative to previous trades.Bollinger Bands...
— a range of price volatility
- Parabolic SAR
In the field of technical analysis, Parabolic SAR is a method devised by J. Welles Wilder, Jr., to find trends in market prices or securities...
— Wilder's trailing stop based on prices tending to stay within a parabolicIn mathematics, the parabola is a conic section, the intersection of a right circular conical surface and a plane parallel to a generating straight line of that surface...
curve during a strong trend
- Pivot point
A pivot point is a price level of significance in technical analysis of a financial market that is used by traders as a predictive indicator of market movement. A pivot point is calculated as an average of significant prices from the performance of a market in the prior trading period...
— derived by calculating the numerical average of a particular currency's or stock's high, low and closing prices
- Ichimoku kinko hyo — a moving average-based system that factors in time and the average point between a candle's high and low
Price-based indicators
These indicators are generally shown below or above the main price chart.
- Average Directional Index
The Average Directional Index was developed in 1978 by J. Welles Wilder as an indicator of trend strength in a series of prices of a financial instrument...
— a widely used indicator of trend strength
- Commodity Channel Index
The Commodity Channel Index is an oscillator originally introduced by Donald Lambert in an article published in the October 1980 issue of Commodities magazine ....
— identifies cyclical trends
- MACD
MACD is a technical analysis indicator created by Gerald Appel in the late 1970s. It is used to spot changes in the strength, direction, momentum, and duration of a trend in a stock's price....
— moving average convergence/divergence
- Momentum
Momentum and rate of change are simple technical analysis indicators showing the difference between today's closing price and the close N days ago. Momentum is the absolute difference in stock, commodity:...
— the rate of price change
- Relative Strength Index (RSI)
The Relative Strength Index is a technical indicator used in the technical analysis of financial markets. It is intended to chart the current and historical strength or weakness of a stock or market based on the closing prices of a recent trading period...
— oscillator showing price strength
- Stochastic oscillator
In technical analysis of securities trading, the stochastic oscillator is a momentum indicator that uses support and resistance levels. Dr. George Lane promoted this indicator in the 1950s. The term stochastic refers to the location of a current price in relation to its price range over a period...
— close position within recent trading range
- Trix
Trix is a technical analysis oscillator developed in the 1980s by Jack Hutson, editor of Technical Analysis of Stocks and Commodities magazine. It shows the slope of a triple-smoothed exponential moving average...
— an oscillator showing the slope of a triple-smoothed exponential moving average
Breadth Indicators
These indicators are based on statistics derived from the broad market
- Advance Decline Line
The advance–decline line is a stock market technical indicator used by speculators to measure the number of individual stocks participating in a market rise or fall...
— a popular indicator of market breadth
- McClellan Oscillator
The McClellan oscillator is a market breadth indicator used by financial analysts of the New York Stock Exchange to evaluate the rate of money entering or leaving the market and interpretively indicate overbought or oversold conditions of the market....
- a popular closed-form indicator of breadth
- McClellan Summation Index
The McClellan oscillator is a market breadth indicator used by financial analysts of the New York Stock Exchange to evaluate the rate of money entering or leaving the market and interpretively indicate overbought or oversold conditions of the market....
- a popular open-form indicator of breadth
Volume-based indicators
- Accumulation/distribution index
Accumulation/distribution index is a technical analysis indicator intended to relate price and volume in the stock market.-Formula:This ranges from -1 when the close is the low of the day, to +1 when it's the high. For instance if the close is 3/4 the way up the range then CLV is +0.5...
— based on the close within the day's range
- Money Flow
Money Flow Index is an oscillator calculated over an N-day period, ranging from 0 to 100, showing money flow on up days as a percentage of the total of up and down days. Money flow in technical analysis is typical price multiplied by volume, a kind of approximation to the dollar value of a day's...
— the amount of stock traded on days the price went up
- On-balance volume — the momentum of buying and selling stocks
See also
- Market analysis
A market analysis studies the attractiveness and the dynamics of a special market within a special industry. It is part of the industry analysis and this in turn of the global environmental analysis. Through all these analyses the chances, strengths, weaknesses and risks of a company can be...
- Market timing
Market timing is the strategy of making buy or sell decisions of financial assets by attempting to predict future market price movements. The prediction may be based on an outlook of market or economic conditions resulting from technical or fundamental analysis...
- Price action trading
The concept of price action trading embodies the analysis of basic price movement as a methodology for financial speculation, as used by many retail traders and often institutionally where algorithmic trading is not employed, and at its most simplistic, it attempts to describe the human thought...
- Chartered Market Technician
Chartered Market Technician is a professional designation that confirms proficiency in technical analysis of the financial markets. To hold the designation, membership in the Market Technicians Association is required....
- Behavioral finance
Behavioral economics and its related area of study, behavioral finance, use social, cognitive and emotional factors in understanding the economic decisions of individuals and institutions performing economic functions, including consumers, borrowers and investors, and their effects on market...
- Mathematical finance
Mathematical finance is a field of applied mathematics, concerned with financial markets. The subject has a close relationship with the discipline of financial economics, which is concerned with much of the underlying theory. Generally, mathematical finance will derive and extend the mathematical...
- Multimedia Information Retrieval
Multimedia Information Retrieval is a research discipline of computer science that aims at extracting semantic information from multimedia data sources. Data sources include directly perceivable media such as audio, image and video, indirectly perceivable sources such as text, biosignals as well...
Further reading
- Douglas, Mark. The Disciplined Trader. New York Institute of Finance, 1990. ISBN 0-13-215757-8
- Edwards, Robert D.; Magee, John; Bassetti, W.H.C. Technical Analysis of Stock Trends, 9th Edition (Hardcover). American Management Association, 2007. ISBN 0-8493-3772-0
- Hurst, J. M. The Profit Magic of Stock Transaction Timing. Prentice-Hall, 1972, ISBN 0-13-726018-0
- Lefèvre, Edwin. Reminiscences of a Stock Operator
Reminiscences of a Stock Operator is a 1923 novel by American author Edwin Lefèvre which is the thinly disguised biography of Jesse Lauriston Livermore...
. John Wiley & Sons Inc, 1994. ISBN 0-471-05970-6
- Pring, Martin J. Technical Analysis Explained: The Successful Investor's Guide to Spotting Investment Trends and Turning Points. McGraw Hill, 2002. ISBN 0-07-138193-7
- Raschke, Linda Bradford; Connors, Lawrence A. Street Smarts: High Probability Short-Term Trading Strategies. M. Gordon Publishing Group, 1995. ISBN 0-9650461-0-9
- Wilder, J. Welles. New Concepts in Technical Trading Systems. Trend Research, 1978. ISBN 0-89459-027-8
External links
International and national organizations