Technical Analysis: A Pseudoscience or Cash Cow?

What is it?

Technical analysis is a method of evaluating investments by analysing statistical trends and changes in price and volume from trading activity. The focus of technical analysis is on price movement patterns, trading signals, and other analytical charting tools that help investors judge and forecast how the market acts upon a security. The underlying assumption with technical analysis is that security prices already reflect all publicly available information out there, and the statistical analysis of price movements will be another useful indicator of the future.

Technical analysis applies to any type of security (stocks, bonds, derivatives, etc.), as long as you have historical trading data that includes prices and trading volume. While technical analysis is a very common tool for forex and commodities trading, it can sometimes be useful in trading stocks and helps investors gain knowledge about the market outside of fundamental factors.

Fundamental vs. Technical Analysis

Fundamental analysis looks at the intrinsic value of a company by accounting for several pieces of information in the market. This includes the earnings and different financial statements of a company, the internal management and future business plans, and the external environment (economy, demand for product, competitors). An analyst will use these pieces of information to determine a stock’s fair value, or what the sale price in the market would be if all parties in the transactions had complete knowledge about the security.

Technical analysts assume that all information studied by fundamental analysts is already factored into the price of a given stock, ETF, commodity, currency, or any other trading vehicle.

This hypothesis is a recurring theme with technical analysis. Charles Dow, considered to be one of the founders of technical analysis, outlined two basic assumptions to shape technical analysis:

1. Markets are efficient with values representing factors that influence a security’s price, but
2. Market price movements are not purely random but move in identifiable patterns and trends that tend to repeat over time.

Let’s break this down.

Efficient Market Hypothesis (EMH):- a security’s price in the market at any given time accurately reflects all of the available information.

Market efficiency is the degree to which the market accurately reflects all available information. Charles Dow’s first assumption is that the market price of something reflects the sum total knowledge of market participants. While this idea is generally true, sudden news and announcements can also affect a security’s price in the short or long term. Thus, it isn’t a perfectly applicable theory, but it still is worth considering.

Dow’s second assumption is that price changes are not random, and market trends, both short term and long term, exist. Therefore, market trends can be analysed to make investment decisions.

Today, the underlying assumptions with technical analysis are:

1. The market discounts everything.

Everything from company fundamentals to market psychology are priced into a stock. The only factor remaining for investment decisions are analysing price movements, which is the product of supply and demand.

2. Price moves in trends.

Stocks move in short, medium, and long term trends. A stock price is more likely to continue a past trend than move erratically.

3. The past will happen again

Price movements are repetitive in nature. Market psychology, a major factor in price trends, is predictable. Emotions like fear and excitement can be analysed through chart patterns.

How is Technical Analysis Used?

In general, technical analysts look at the following broad issues:

• Price trends
• Chart patterns
• Volume and momentum indicators
• Oscillators
• Moving averages
• Support and resistance levels

Different types of traders may use different methods of technical analysis. Day traders might simply analyse trend lines and volume indicators to make short-term decisions. Swing or position traders (‘longing’ an asset) may prefer chart patterns and specific technical indicators. Other traders, especially institutional investors, use algorithmic trading tools with varying requirements and variables that combine volume and technical indicators for decision making. While these topics can be discussed in greater depth, we’ll go over some specific examples of technical analysis. We encourage you to further research and learn these broader technical analysis concepts!

Price-Volume Relationship

Changes in prices and trading volume (how much of an asset is traded during a period) are the foundation of technical analysis. Price shows how the market is valuing a stock, and volume indicates the supply/demand relationship. A rising market should see rising volume as buyers need increasing numbers and increasing enthusiasm to keep prices pushing higher. However, increasing price and declining volume shows a lack of interest, or demand, and warns of a potential trend reversal. When a price rises or drops on large volume, it’s a stronger indicator of some type of fundamental change (e.g. earnings report, levering up, etc.)

Chart Basics

Candlesticks

Price patterns are identified using a series of trend lines/curves. Trendlines will vary depending on what part of the candlestick, or price bar the dots are connected. The body of the candle bar is usually where most of price action occurs, and therefore might provide more accurate points, like the closing price, to draw a trendline. The upper shadow shows where the daily high is, and the lower shadow has the daily low. The shadows are considered outliers, but still relevant indicators of volatility during the short-term.

Patterns

Continuation patterns denote a temporary interruption of an existing trend. This is thought of as a pause in a prevailing — when a bull catches its breath during an uptrend, or bears relax momentarily during a downtrend. When a price pattern is forming, there’s no telling if it will continue for a while, or reverse. Therefore, technical analysts pay close attention to trendlines and when a price will break above or below a continuation zone.

Common continuation patterns include;

• Pennants — made from two converging trend lines
• Flags — drawn with two parallel trend lines
• Wedges — constructed with two converging trendlines, both angled either up or down

Pennants are drawn from two trend lines that eventually converge. The trend lines move in two directions — one in uptrend and another in downtrend. Frequently, volume will decline when a pennant is formed. This is followed by a volume increase when price inevitably soars.

Flags are formed with two parallel trend lines that can slope up, down, or sideways (horizontal). Generally, flags appear during a pause in a downtrend.

Finally, a wedge is drawn using two converging trendlines. A wedge is characterized by both trendlines moving in the same direction, either up or down. A wedge angled down shows a pause in an uptrend. An angled up wedge shows a pause during an uptrend.

Technical Pattern — Head and Shoulders

A head and shoulders pattern is formed with three peaks, with the outside two similar in height, and the middle one the highest (resembling a head and shoulders). This formation is often identified as predicting a bullish or bearish trend reversal. A H&S formation can tell an investor 3 things;

1. After a long-term bullish (or bearing) run, the price reaches a peak and eventually drops to form a trough.
2. The price increases a second time even higher than the first, and falls again.
3. The price will rise a third time to the height of the first peak, before reversing and (sometimes) coming back down to the neckline.

This is a specific example of a chart pattern that can be used to analyze a ‘tug-of-war’ between bulls (those who believe the price will rise) and bears (those who believe it will go down). Whether the price rises or drops depends on how many people are on each team. If more shareholders are bears, they’ll want to sell it more, decreasing the price. If there is more demand and shareholders want to take advantage of the opportunity, the price will increase. This is just one example of a chart pattern formation that can be analyzed for decision making.

Technical Indicator — RSI

A technical indicator is a mathematical calculation based on price, volume, or open interest of a security. An example of this is the Relative Stress Index (RSI). It is a momentum indicator measuring the magnitude of recent price changes to evaluate overbought or oversold conditions in the price of a stock. An RSI is displayed as an oscillator — a line on a graph that moves between two extreme values and builds a trend — and this can have a reading between 0–100. Traditionally, if RSI values are above 70, the security may be overbought and overvalued, and thus set for a trend reversal or corrective pullback in price. An RSI below 30 could indicate that the security is oversold and thus undervalued.

The RSI has a two part calculation that begins with this formula:

The average gain or loss is the average percent gain or loss during a period. This formula uses positive values of losses. If we examine the closing price of Amzn stock in the past 14 days since February 13, 2020, the average gain is 2.65% and the average loss is 0.7%.

Once there are 14 periods of data available, the second step smoothens the results. Current gains and losses are the gains and losses of the latest trading day. This makes the data more up to date.

According to our calculation, the RSI is 79.1. This simply indicates that Amazon could be overvalued. You’d update your calculation on a daily basis to account for the previous trading day. While a 14 trading period was analyzed in this example, 10-day RSI is more likely to reach an oversold or overbought condition due to a smaller amount of data inputs.

How can TA be useful?

Technical analysis sometimes helps investors understand the market sentiments behind technical trends and make predictions on price movement. It is also most useful when used on top of fundamental analysis. If you have discerned that a company’s management is stable, its business activities are strong, and fundamentals have grown steadily, then technical tools may help you forecast/estimate where the price looks to be heading in a specific period.

In addition, technical analysis helps investors determine entry/exit points in the short term. This is the price at which an investor buys or sells a security. Good entry points in a trending market come after a short counter-trend move or a period of consolidation (when a trend is neither continuing or reversing). Using trendlines, moving averages, and other indicators help to determine suitable entries/exits.

You could find clear trends and patterns that you think might continue or reverse based on past trends, fundamental factors, and environmental conditions.

What are its limitations?

Nonetheless, you should keep a giant asterisk on these statements. During a period of volatility or very random price/volume movements, technical analysis alone won’t help you see the big picture. This is known as weak-form efficiency.

Weak Form Efficiency:- future securities’ prices are random and not influenced by past events.

Essentially, past price movements, volume and earnings data do not affect a stock’s price and can’t predict its future direction. Moreover, daily price fluctuations are entirely independent of each other. Weak-form efficiency doesn’t consider technical analysis to be accurate. It asserts that it is difficult to outperform the market, especially in the short term.

The effective market hypothesis (EMH) is also a major hurdle to the legitimacy of technical analysis. Assuming that all past and current information are reflected in the market also makes sure that there’s no way to take advantage of patterns or mispricings to earn more profits or an alpha. Advocates of fundamental analysis believe that no actionable information is contained in historical prices and volume data, and price trends do not repeat themselves. Instead, real-time information will impact the price. Any event can occur, and prices thus move as a random walk.

Actually, weak-form efficiency happens in the market a lot of the time. Nobody ever knows how the market is going to react because it’s not influenced by a constant set of factors. It’s very difficult to conceptualize this, but remember that the stock market is unpredictable. Sure, there are uptrends and downtrends, but when do you know when they will reverse? Price and volume stats, among other TA tools, won’t alone help you understand where the market is going or how a security is being valued. Fundamental analysis is arguably more important for investment decisions because it gives a clearer picture of the business you’re investing in as opposed to market conditions, which can have weak form efficiency.

Conclusion

Is technical analysis good or bad? It depends. Over-reliance on statistics rather than fundamentals is unwise. However, using some technical indicators or short-term price/volume charting techniques to supplement an investment decision usually isn’t necessarily bad. The best investors use their logic and reasoning to evaluate a stock, and fundamental analysis allows one to exercise this skill, whereas technical analysis is based on unsound principles.

“Risk comes from not knowing what you’re doing.” — Warren Buffet.

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