Technical Analysis

It is every investor’s dream to be able to predict the market. There already is a way and it is called data analysis. There are two categories of data analysis: fundamental analysis and technical analysis.

The basis of fundamental analysis is, unsurprisingly, the fundamentals of an investment. This can include market sentiment, economic indicators, and company earnings reports. Technical analysis, on the other hand, uses historic trends to predict how an investment will perform in the future. Here, Market10 takes an in-depth look at technical analysis.

Understanding technical analysis

Analysts have long known that economic performance is cyclic in nature. Taken over an adequately broad period, the value of any individual commodity, share, market or economy follows a general up-and-down pattern. There are variations caused by myriad factors but certain trends emerge in the long-term.

Technical analysis attempts to decipher these patterns to predict when a rise or fall will occur. With the right technical analysis, you can correctly decide when to enter or exit a market.

The critical tool of technical analysis is a chart that tracks any price or value. It is distinguishable by its unique structure and colour.

The green parts indicate an increase in value while red segments signify a decrease. Each green or red section is made up of a thick line called the candle. The candle shows the range between the opening and closing price. Above and below each candle is a thinner line called the wick. The wick shows the range between the highest and lowest price for that period.

To a novice, a technical analysis chart can look simply like a virtually random series of movements. However, when paired with real-world information like time of day, week or year and current events, a pattern begins to emerge. Some of these patterns can be detected fairly easily while others are only uncovered by specialized computer programs.

It is not enough to extract a pattern from the chart. A valid hypothesis can only be formed after that theory of the rise and/or fall can be applied to many, if not all, previous price movements. To decide whether a theory is universally or widely applicable, we use a ‘back test’.

Back testing takes a proposed theory and tests it against actual data. For example, a trader may suggest that the price of the US dollar weakens against the Euro every Friday before the forex markets close. A back test will analyse the weekly USD/EUR figures as far back as possible and verify or discredit the hypothesis.

If a back test confirms a theory, a trading company may automate their trades based on the verified indicators. Using the above example, they may set up a schedule to buy USD on Friday and sell it for EUR before the following Friday.

What is the basis of technical analysis?

The famed Dow Jones Industrial Index (DJIA) was founded by and partly named for the pioneer of technical analysis, Charles Dow (1851-1902). He established what we know today as the Dow Theory, which states that the price of any commodity or stock is guided by three (3) Principles:

Averages

Regardless of fluctuations, the average value is a reflection of all the factors that affect it.

Trends

A trend emerges when there is consistent movement in a particular direction, up or down. It consists of three (3) parts:

• Primary – The maximum point of the increase or decrease.
• Secondary – A correction of the primary movement, this is a reversal in direction usually by half but generally in the range of one-third to two-thirds.
• Minor – Small fluctuations in the secondary movement.

Phases

Primary trends have three (3) distinct phases:

• Accumulation – Perceptive investors identify a trend and enter the market.
• Public participation – The trend becomes popular and a larger number of traders enter the market.
• Distribution – The widespread adoption of the trend which is followed by a huge increase in trading volume.

How is the technical analysis used?

Recognizing a trend early is central to the success of any technical analysis. The time frame does not matter – it can be an indicator of price changes that occur daily or fluctuations over the course of a year.

A trader who correctly recognizes a trend as it starts can invest in securities, futures or CFD (contract for difference) market with a small investment and maximize profits by pulling out before the trend reverses.

Technical analysis may also be used to offset losses. For example, consider an investor may have bought a stock that has fallen and incurred a loss.

If the technical analysis shows that the downward trend will continue for another 3 months, he can invest in a CFD by taking that position. If the analysis is correct, he will profit from the fall in stock price. Consequently, when the trend reverses in 3 months, he can sell the stock and make a profit there, too.

Technical analysis vs Fundamental analysis

We explained in the first section that technical analysis is concerned with trends while fundamental analysis revolves around company, industry and market fundamentals.

An investor using fundamental analysis does not look at large data sets of market movements. Their focus is primarily on the ‘here and now’ factors that have a direct impact on value. They use this information to decide whether the value is likely to increase or decrease.

In this sense, it may be possible that fundamental analysis and a technical analysis come to diametrically opposite conclusions.

For example, technical analysis may indicate that the value of a stock is at the start of a downwards trend because of the time of the year. On the other hand, fundamental analysis may look at the firm’s incoming CEO, new product launches and government grants as indicative of upward pressure on the stock price.

The best approach to investment is to not view it as technical versus fundamental analysis but rather technical plus fundamental analysis.

Advantages and Disadvantages

The chief advantage of technical analysis is the first Principle of the Dow Theory that averages are key. Irrespective of minor fluctuations, the average value of any variable evens out over a period. If your technical analysis correctly identifies a trend, you can make profits instantly as well as in the long-term.

The most obvious disadvantage of technical analysis is uncertainty. There is simply no guaranteed formula for identifying a trend; even market movements that fit neatly into historic trends are susceptible to unpredictability. In other words, if your technical analysis wrongly identifies the trend, then a loss may occur.

A perfect example is the 2020 COVID-19 pandemic; it completely offset all previously accepted projections by a wide margin.

At Market10, we understand the strengths and weaknesses of technical analysis, which we factor into our investment decisions.