There’s no question whether or not any active securities trader nowadays need to have a high level of knowledge on technical analysis, of course some people put more efforts in the fundamental analysis but they do keep their eyes on technical indicators, and how other traders will or might react according to what those indicators suggest.
This article will be a first step in understanding technical analysis, we will have more info on this topic in some upcoming articles. Now lets start with the question ” What is technical analysis?”.
Technical analysis is a form of analyzing securities based on price and volume, in addition to other concepts that will be built based on those two variables, data is mostly displayed graphically in order to get to our final decision. Before engaging in technical analysis you must be sure that the market you are trading in is a free market as possible otherwise indicators will have no meaning, one common way to know that is to take into account that prices are a result of supply and demand, and that there’s no single trader who is big enough to influence the prices or manipulate them, you should also make sure that information in the market is easy to obtain and available to everyone this way there’s no trading based on material non public information or insider trading, this will be explained with more details during this article. (Note: these assumptions are not fully connected with the assumption that the market is efficient since technical analysis deals with the inefficiencies in the market that rise because of the emotions of traders).
This might sound funny but technical analysis allows you to trade on securities that you have no clue about! what they represent, or how they work, technical analysis is only based on charts and movements of prices and volumes, this is why as mentioned earlier you should make sure that the market is as free as possible and prices cant be manipulated easily.
There are several time frames for technical analysis starting from 1 minute up to years, however its mostly known that technical analysts such as traders do stick to short time frames unlike fundamental analysts.
How do People look at technical analysis? and what assumptions are held in that matter?
The fact is that technical analysis is hardly viewed as a science itself, it is based on understanding the psychology of people, how they react to different events and what their emotions are when they expect something, which is logical ! I mean prices are set by us and our emotions after all! human beings do set prices based on supply and demand and the latest does get affected highly by emotions and sentiments.
So, when our emotions are a key factor in our behavior as human beings we cant exclude their effect on securities prices, fundamental analysts argue that we can find the intrinsic value of securities based on the fundamental analysis we make taking into account that markets are efficient. Technical analysts however do see that emotions affect our decisions which will explain the irrational behavior of traders and all of that can be viewed in the prices’ graphs we see.
We can clearly say that technical analysis is based on factors that are visible and agreed on by market participants(price, volume) while fundamental analysis is based on conclusions of financial statements and different sources of information which makes fundamental analysis a little bit laggy if the analyst came to a conclusion that isnt yet observed by other market participants, even if that conclusion was correct it might not show effect on the market trends till more and more analysts come to the same conclusion.
Drawbacks of technical analysis
As mentioned earlier, technicians make their calls based on different patterns they observe in the price graphs, they do not take into account factors other than that, they do not make a study of expected demand on a company’s products in order to predict future price changes, which means that prices might not be precise since price trends take time to be evident which might require technicians to change their recommendations.
Another drawback is that trends might take time to be recognizable, which means that technical analysis might take time to identify changes in trends or patterns leading to incorrect recommendations for investors.
To conclude this article we should mention that technical analysis has been used way before fundamental analysis as records show that technical analysis were first used in the 1700s in Japan to trade rice, however it was used by traders in the western markets in the 1970s. Technical analysis has been used through history but unluckily for us it wasn’t analyzed properly and a lot of academicians believe that this field has no concrete base and shouldn’t be taken seriously in isolation to other fields, however, in most cases of fraud such as manipulating financial statements technical analysts have shown higher returns over fundamental analysts.