Technical Analysis: Using the Past to Forecast the Future

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Technical analysis is an analytical system that looks for buy and sell signals in patterns formed in charts of stock prices. A strict technical analyst wouldn’t do any business or financial analysis, instead preferring to look only at the charts. A different approach, favored by many small cap investors, is to do the fundamental business and financial analysis first, then use technical analysis to look for good places to buy and sell the stock.

Technical analysis utilizes the research of historical price activity and the application of momentum studies to provide a picture of where the market has been, and to help forecast where the market might be headed.

So-called Japanese candlestick charting methods date back some 300 years, and were first used to help analyze market direction for rice trading. Basic western style charts for decades have been constructed to display price action, but the application of technical analysis for trading purposes has been widely accepted only since about the early 1980s. Before then, many fundamental analysts dismissed technical analysis research as little more than “voodoo.” At that time, the use of technical analysis was not widely embraced by the investment community and was basically ignored by the financial press. Throughout the late 1980s and into the 1990s forward to today, it became apparent to many investors that technical analysis offered vital market information, and as a wave of chart-driven money managers entered the marketplace, technical analysis gained in importance. Today nearly every major market research firm in the world now includes technical analysis study within their cache of work.

Technical analysis is valuable because it provides a tool to help explain investor behavior. Technical analysis generates a visual mechanism to understand price movement,and it helps to level the playing field for those not privy to fundamental insider information.

Market technicians believe that technical analysis research can provide clues to understanding how investors behave toward a stock or toward the market in general. Once armed with a feel for some basic momentum studies and chart patterns, market technicians believe they can better understand why a market can suddenly reverse course and stall out on a trend.

Humans are visual animals, and there is a reason for the adage, “a picture is worth a thousand words.” When novices look at a price chart, they often see only a plot of points connected on a graph; to an experienced technical analyst, that chart comes alive to tell a story of triumph, defeat, sudden twists and surprising turns. And experienced technical analysts can interpret that information to make knowledgeable guesses about the next move.

In fact, many technicians will say that market fundamentals such as supply and demand don’t even matter, that they are simply part of the puzzle already reflected in the chart picture. For the most part, that is taking technical analysis to an extreme, and it is better to consider chart analysis as simply one more tool to help us become better investors. There are highly successful traders who only use a fundamental approach, and there are equally impressive traders who rely on technical analysis for their trading decisions.

GLOSSARY OF TECHNICAL ANALYSIS TERMS

Support & Resistance – uses chart patterns or momentum readings to identify price points where buyers should enter, or sellers should emerge.

Overbought/Oversold – typically engages momentum studies to suggest that a market is ready to stall on a trend.

Trendline – connects previous lows (on an upmove) or highs (on a downmove) to identify support and resistance moving ahead. Trendlines are also valuable to suggest a trend breakout when breached.

Candlesticks – Japanese style charting method that uses high, low & close data to form a “candle” that is a great visual charting tool. Candlesticks charts also carry their own set of patterns that are valuable research tools.

Engulfing Pattern – Candlestick pattern that is the equivalent of an “outside” session on traditional charts. Reversal pattern that shows extreme market activity.

Double Top/Double Bottom – formed when the market has approximately equal price extremes at highs or lows (can be done on intraday, daily, weekly and monthly charts) . Often serves as a key resistance/support point, and a turning zone for the market.

Gap – formed when the market opens or makes a sudden move outside of the existing range. Often a breakaway pattern indicator.

Inside Session – when the market is stuck on a tight range inside the previous session; suggests indecision and a potential shift in trend.

Head & Shoulders – chart formation that suggests a top on the upside (inverted pattern for bottom) . Actually looks like a person’s head and shoulders on the chart.

MACD – A combination of three exponentially smoothed moving averages.

Fibonacci – namesake of Italian mathematician. Based on the concept that nature (and markets) tend to cycle in regular math variables. Used in technical analysis primarily to identify support and resistance based on these numbers retracement numbers (38.2%/50%/61.8%) .

Flag/Pennant – continuation pattern formed after a breakaway move; looks like a flag on the chart.

Moving Averages – averages prices over a period of time; helps as use for support/resistance and also as a trend breakout.

Stochastics – measure the relative position of the closing price as compared to its range over a given time period. Generally, 30% or lower is considered oversold, while 70% or higher is considered overbought.

RSI (Relative Strength Index) – Compares the ratio of up to down closes over a period of time.

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