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The Essentials of Technical Analysis: Part I

1 of 3 Educational articles on the subject of Technical analysis of stock trading patterns.
By: Jack Haddad, MD, MBA, CMT, DITA

Technical analysis has been around for as long as there has been organized markets in the form of exchanges. But, it was not long ago (late 70s to early 80s) when Wall Street, major funds, and financial institutions accepted technical analysis as a viable tool for making money. Before then, technical analysis was regarded as a form of mystical hocus-pocus.  Now, however, with the scandalous rise of corporate dishonesty, shenanigan business practices, the purely fundamental analyst is virtually extinct.  

Technical analysis of observable and quantifiable trading patterns can be used to develop investment strategy.
Why the change?  What cause this dramatic shift (fundamental to technical) in perspective? According to the Market Technicians Associations (MTA), more than 30 US colleges and universities are currently offering accredited courses in technical analysis (see appendix A). The MTA, an organization founded in 1993, defines our professional code of ethics and promotes the development of technical analysis. Through the effort of the MTA, a third program has emerged that leads to chartered Market Technician (NYSEMKT:CMT) and a diploma in technical analysis (DITA). If you have an interest in earning a CMT or DITA, the best place to start is by contacting the MTA.

Technical versus fundamental analysis:

To aid in the comprehension of how technical analysis works, one needs to know that a finite number of traders participate in the markets on any given day. These individuals interact with each other on the trading floor and form collective behavior patterns. These patterns are not only observable and quantifiable, but also repeat themselves with statistical reliability; that said, technical analysis is a method that organizes these collective behavior patterns that give clear indications of when there is a greater probability of one thing occurring over another. Fundamental analysis attempts to take into consideration mathematical models that weigh the significance of a variety of variables (corporate earnings and revenues, price-to earnings ratio, gross margins, valuations, etc..) that could effect the relative balance or imbalance between the supply and demand of a particular stock, commodity, or financial instrument. The trouble is that this economic equation that defines the laws of supply and demand does not have an exponential variable to quantify fear or greed.

Fear or greed is an element of human nature which is called market sentiment or behavioral analysis, and fundamental analysis gives it no consideration. It's people who express their beliefs and expectations about the future that make prices move and not fundamental models. The fact that a fundamental model makes a logical and reasonable projection is not much value if traders who are responsible for most of the trading volume are not aware of the model or simply don't believe in it. Bob Prechter, a famous practitioner of technical analysis once commented that, "... the main problem with fundamental analysis is that its indicators are removed from the market itself. The analyst assumes causality between external events and market movements, a concept which is almost certainly false. But, just as important, and less recognized, is that fundamental analysis almost always requires a forecast of the fundamental data itself before conclusions about the market are drawn. The analyst is then forced to take a second step in coming to a conclusion about how those forecasted events will affect the markets! Technicians only have one step to take, which gives them an edge right off the bat. Their main advantage is that they don't have to forecast their indicators."

Main difference between the two types of analysis:

Fundamental analysis - Focuses on what ought to happen in a market
Technical analysis - Focuses on what actually happens in a market

Factors involved in price analysis:

1. Supply and demand
2. Seasonal cycles
3. Weather
4. Government policy
5. Is a medley of Science & art. No algebraic / empiricalformulae.
6. Involves study of price charts and oscillators derived thereon.
7. Study regards price as the ultimate factor, which factors in fundamental factors as well. Does not     subscribe to the random walk theory.
8. Signals generated by market action on prices.
9. Chances of multiple interpretations are higher.
10. Will generate more signals, works for catching MOST price movements.
11. Will generally generate signals in advance.
12. Involves built-in capital / risk management techniques.

Charts are based on market action involving:

1. Price
2. Volume
3. Open interest (futures only)
4. Is a pure science form, involves pre-set parameters for investment decision support systems.
5. Involves study of Balance Sheets, P & L accounts.
6.Study regards price moves as a random phenomena, caused by market forces.
7. Signals generated by corporate actions.
8. Chances of multiple interpretations are lower.
9. Will generate fewer signals, works better for catching major moves.
10. Will generally generate delayed signals.
11. Involves NO risk / capital management techniques.