We often say that technical analysts see the market as 80% psychological and 20% logical. Fundamental analysts see the market to be 20% psychological and 80% logical. Who’s right?
Neither is completely right, but both have the same aim. It’s their methods that are different. The aim of technical analysis is to forecast, through the study of charts, future price actions of a traded asset. The analyst’s works is divided into two subjects: prices and volumes. Technical analysts also do their research with two main ideas always in the back of their mind.
The first idea is that market price action takes everything into account. It means that the price is the reflection of all the data that influences price movement. All the economic, financial, political or psychological factors are taken into account and reflected in the price chart.
The direct consequence of this assumption is an emphasis on the chart itself. The most important aspect of trading is tracking and analysing the price action as it is expressed in the chart. The market itself, through the chart, shows the direction the share will more than likely follow. That’s why, unlike fundamental analysis (balance sheets, book value, earnings estimates), technical analysis does not pay attention to the study of the factors that “make” the price.
The second main idea that occupies the brain of the technical analyst is that history repeats itself. It doesn’t always do so perfectly. But past patterns can often unlock the direction of future price movements. The key to this insight is that chart patterns, in some direct way, reflect that patterns of human behaviour.
Indeed, the price action of an asset is the result of decisions made by human beings. Human beings, as you know, are driven by their own particular psychology and their own unique emotions. This emotional aspect of trading remains the same over the years as human beings don’t change (we remain fearful, greedy, stupid, bold, and terrified). We may think we are much smarter than people who lived a thousand years ago. But in evolutionary terms, our brains work (or don’t work) in exactly the same fashion as our ancestors.
Mass psychology is also a constant in civilised society. We know how, roughly speaking, crowds behave. The chartist understands that patterns and market dynamics that have occurred in the past are a major key to forecasting the future. Though they aren’t perfectly predictive, they are certainly worth studying.
By focusing on the price action (what the price is now, where has it come from, where is it going), technical analysis tries to determine the predominating forces in the market, be they bullish, bearish, or somewhere in between. As a trader, you can see how that would be a useful little skill.
However, caveat emptor. Technical analysis is more a skill than an objective science. Indeed, unlike most scientists, technical analysts affect what they observe by their own actions. If you use pattern detection to influence your trading decisions, the pattern you think you see in some ways becomes self-fulfiling.
Technical analysts influence and “build” the price action by their trading decisions. They are not neutral observers. They affect what they observe. That’s why, despite the global rules of technical analysis we’ll cover in the coming weeks, you should keep in mind that technical analysis is subjective and is open to diverse interpretations. It is often only as good as the analyst himself.
Among market players, each trader has his own tool box of indicators and has his own style when following chartist rules. Point and figure, Elliott Wave theory, moving averages, Bollinger bands…there are many technical theories and many technical tools. Some of them strictly apply the global rules while others set up a more flexible approach with a different degree of trust.
Which ones can you trust? A lot depends on which market you are trading. The currency markets, for example (where I spent most of my professional career), rely heavily on technical analysis. The share market does too, but to a lesser degree. Commodities, bonds, shares…you can apply the tools of technical analysis to these markets with varying degrees of success. More on the tools of technical analysis and the various styles of trading next time.
for The Daily Reckoning Australia