Basis of Technical Analysis of a stock or security

What makes Technical Analysis an effective tool to analyze price behaviour is explained by the following theories are given by Charles Dow:

  • Price discounts everything
  • Price movements are not totally random
  • What is more important than why

Price discounts everything

“Each price represents a momentary consensus of the value of all market participants – large commercial interests and small speculators, fundamental researchers, technicians and gamblers- at the moment of transaction” – Dr Alexander Elder

Technical analysts believe that the current price fully reflects all the possible material information which could affect the price. The market price reflects the sum knowledge of all participants, including traders, investors, portfolio managers, buy-side analysts, sell-side analysts, market strategist, technical analysts, fundamental analysts and many others. It would be folly to disagree with the price set by such an impressive array of people with impeccable credentials. Technical analysis looks at the price and what it has done in the past and assumes it will perform similarly in future under similar circumstances. Technical analysis looks at the price and assumes that it will perform in the same way as done in the past under similar circumstances in future.

Price movements are not totally random

Technical analysis is a trend following system. Most technicians acknowledge that hundreds of years of price charts have shown us one basic truth – prices move in trends. If prices were always random, it would be extremely difficult to make money using technical analysis. A technician believes that it is possible to identify a trend, invest or trade based on the trend and make money as the trend unfolds. Because technical analysis can be applied to many different time frames, it is possible to spot both short-term and long-term trends.

“What” is more important than “Why”

It is said that “A technical analyst knows the price of everything, but the value of nothing”.

Technical analysts are mainly concerned with two things:

  1. The current price
  2. The history of the price movement

All of you will agree that the value of any asset is only what someone is willing to pay for it. Who needs to know why? By focusing just on price and nothing else, technical analysis represents a direct approach. The price is the final result of the fight between the forces of supply and demand for any tradable instrument. The objective of the analysis is to forecast the direction of the future price. Fundamentalists are concerned with why the price is what it is.

For technicians, the why portion of the equation is too broad and many times the fundamental reasons given are highly suspect. Technicians believe it is best to concentrate on what and never mind why. Why did the price go up? It is simple, more buyers (demand) than sellers (supply).

The principles of technical analysis are universally applicable. The principles of support, resistance, trend, trading range and other aspects can be applied to any chart. Technical analysis can be used for any time horizon; for any marketable instrument like stocks, futures and commodities, fixed-income securities, forex, etc

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