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Technical Analysis

See Also: Technical analysis definition - Technical analysis terms - Technical analysis resources
Key Topics: Elliott Wave Theory - Chaos Theory

Technical Analysis - A Definition

Technical Analysis, sometimes known as Charting (and its exponents as Chartists), is the use of numerical series generated by market activity, such as price and volume traded, to predict future market trends. These techniques can be applied to any market with a comprehensive price history. Technical analysis does not try to analyze the financial data of a company, such as balance sheets, cashflow, dividends and projection of future dividends. The latter type of analysis is called Fundamental Analysis.

While technical analysis is widely used as one of many techniques by both professional and amateur traders as a means of predicting future market moves, it is generally not used by economists for academic purposes.

Technical analysis implicitly ignores market efficiency as understood in the Efficient Market Hypothesis (EMH). EMH asserts that stock prices are determined by a discounting process such that they equal the discounted value (or present value) of expected future cash flows. It also states that stock prices already reflect all known information and are therefore accurate, and that the future flow of news (that will determine future stock prices) is random and unknowable in advance. The EMH is the central concept underlying Efficient Markets Theory (EMT) which is primarily based on notions of rational expectations.

The use of Technical Analysis on a particular market implicitly assumes that that market is not efficient (as defined by EMH). The Efficient Market Theory basically argues that existing prices reflect all available information, and that future price movements will follow a path that will approximate to a random walk as they adjust to new information as it emerges. The theory further assumes that all participants in the stock market have equal and instantaneous access to all information that might affect stocks.

Technical analysts believe that by analysing stock price histories, they can discern sufficient information about the thinking of buyers and sellers to anticipate future events. The assumption is that there is useful information to be obtained, hidden within price histories; and technical analysis is a way of analyzing the past actions of participants in a particular market, as reflected by their actual transactions. Since the assumption of an efficient market is central to almost all Option pricing theory, financial mathematicians generally reject technical analysis as being unscientific. All large investment banks, however, employ both technical analysts and financial mathematicians.

Technical Analysis Techniques

The traditional chartists developed familiarity with chart patterns that seemed to recur repeatedly and gave some of them names, e.g. "head and shoulders" or "flag" or "triangle". They believed that they could infer probabilities of price action from studying the patterns.

More recent technical analysts use a wide variety of techniques but, at their best, their methods approximate more closely to a statistical analysis of price action.

The most sophisticated technical analysis software allows the user to design indicators and to optimise them by testing their profitability (assuming trading rules and transactions costs) using historic data; trading stratagems can be designed that utilise one or more such indicators.

Technical Analysis Terms

Some of the most commonly used Technical Analysis terms and chart patterns are identified on the following page.


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