The Value of Technical Analysis
The reason technical analysis has value is that directional price moves are often sustained for a period of time, allowing analysts to detect and profit from the change in price. The practice of analyzing price and volume movement is ultimately an art in the study of human behavior, despite the fact that technical analysts have access to numerous math-based instruments.
Because human behavior is involved, a technical analyst can never be absolutely confident of future price movements, just as a meteorologist can never guarantee a weather forecast.
Figuring out the what and when…
Three fundamental issues concerning investments are posed to all investors. When to buy, when to sell, and what to invest in. Investors can use technical analysis as a framework to systematically choose stocks and determine when to purchase and sell. Since the investor can create a set of “what and when” guidelines to adhere to, emotion—the investor’s worst enemy—is significantly diminished in these choices. Technical analysts always know how much risk they are taking and know when to “get out while the getting is good,” as opposed to “buying and hoping for the best.
“Only price and volume only…
Only historical price and volume data is used for technical analysis. The underlying premise of technical analysis is that all known information such as what a company does, its financial results, analyst’s ratings, management performance, politics, news, etc. are reflected in the historical price and volume data. This is a powerful concept since it is impossible to gauge how these factors may influence future price separately.
It is important to understand that technical analysis can only be used to determine the likely direction of future prices. It cannot anticipate news events or how investors will respond to them.
The Goal of Technical Analysis
The chart below displays a historical price chart for Analog Devices, Inc. (ADI) for one year.
Historical one year price chart for Analog Devices, Inc. (ADI)
Notice how the stock price can move up, down, or sideways for months. Technical analysis uses methodologies to help indicate when prices are beginning to change direction. The goal of a technical analyst is to buy an equity when the price chart indicates prices are beginning to move up and then sell when the price chart indicates prices are beginning to move sideways or down.
Why Technical Analysis Works
Because price and volume frequently reflect the collective psychology (the “fear/greed balance”) of market participants, technical analysis is effective. Shortly after those adjustments take place, technical charts might show shifts in the fear/greed ratio, which opens up trading possibilities. Technical analysts search for charts that show a recent, expected shift in the fear/greed balance. After that, they try to take advantage of that change by making trades. Technical analysts keep an eye on price and volume for sell indications after purchasing a stock. Technical analysis-based trades have a higher-than-average likelihood of success when executed properly, but strict money management strategies are still necessary to protect against unanticipated market swings.
Misuse of Technical Analysis
Although learning the fundamentals of technical analysis is simple, skillfully putting them into practice is more difficult. As a result, a lot of people have lost money utilizing technical analysis methods and come to the conclusion that chart analysis is useless. Furthermore, regrettably, a lot of gullible investors have bought technological “systems” that guarantee absurd profits with little work. The buyer’s money is long gone by the time they discover that the system is broken. Technical analysis is risky and requires time and effort, just like any other job t hat includes earning money. You shouldn’t trust anyone who says differently. In the past, technical analysis has been abused in the following ways:
The Holy Grail mentality…
One of the most common misconceptions about technical analysis is that it is possible to create a trading system—a set of buy and sell rules—that generates consistent profits with little to no risk.
A “perfect system” cannot be sustained for several reasons. Firstly, the market is made up of people with free will and guided by fear and greed. Prices must consistently move in predictable patterns for a perfect system to work. This will never be possible when people are involved. Second, a lot of financial institutions keep an eye on the market for systematic trading patterns. Once it is discovered, the financial institution is able to take advantage of the system by investing in the system’s favor or against it, which eventually compromises and defeats the “perfect system.” And lastly, what could possibly drive someone to share a “perfect system” at any cost? For the second reason, if too many people or even one institution discovered such a system, it would be of no use to anyone.
Just tell me what to buy…
Investment charlatans and gurus have always been offering advice on how to profit in the market. These are the people who take financial advantage of new and uninformed investors by promising quick and profitable investment success. Claims of ultra-high rates of return or knowledge of future events for substantial fees are the best ways to identify such schemers.
Although a real guru is a spiritual guide or teacher, the title “Market Guru” is gladly accepted by advisers who have developed notoriety with fortuitous calls of major market changes or unusual approaches to investing. New market gurus are frequently crowned by the media on television and the Internet of today. Warren Buffet is one of very few genuine market gurus who has demonstrated his market savvy over decades. The majority of market experts can only offer profitable advice if the market favors their investment philosophy. As their philosophies align with the new market dynamics, new market gurus will emerge as the market changes.
Technical Analysis lets me control the market…
While few people consciously believe that they can control a stock’s price directly, subconsciously, chart analysis can give new investors a false sense of control, which will cause them to lose objectivity: “My stock just broke below my trend line today, but it will come back tomorrow since that is a really good trend line!”
The opposite response, “My stock broke my trend line!” is just as damaging. T/A is worthless!” Technical analysis aims to eliminate the emotion that drives both responses.
In Part 3, we’ll take a critical look at the assumptions that technical analysis makes about the markets.
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