Technical analysis, according to a seasoned veteran technical analyst John J. Murphy, is the study of market action, primarily through the use of charts, for the purpose of forecasting future price trends.
Price, volume and open ineterest, which are termed as 'market action' or 'price action' are the key ingredients used by technical analysts in their analysis.
The technical analysis approach is based on the following three premises:
As for the technical analysts, all that matters is the study of the price action. They believe that anything that can possibly affect the price -fundamentally, geo-politically, psychologically, or otherwise -is indeed reflected in the price of that market.
So is study of price action is all that is required for technicians? And the answer to this question is Yes, but it might sound too bold.
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In pure basics, forces of supply and demand cause shift in price equillibrium.
In other words, if demand exceeds supply, prices should rise. And if supply exceeds demand, prices should fall. This action is the basis of all economics and fundamental forecasting.
Now technicians claim that price action should reflect these shifts in supply and demand.
Accordingly, if prices are rising, for whatever reasons it might be, demand must exceed supply. If prices fall, supply must exceed demand.
As a chartist, they do not care to know why prices rise or fall as long as they know that rising price signals bullish sentiment and the falling price signals bearish sentiment.
The chartists acknowledge that the fundamental reasons exist behind the market movement but they also acknowledge that knowing what those reasons are not necessary to predict the future market price.
Chartists believe trend is a friend until it bends.
The sole purpose of studying price action is to identify the trend so the chartist can trade in the direction of the trend.
COROLLARY: The corollary to this premise states - price tends to move in trends, i.e. a trend in motion is more likely to continue than to reverse.
This is a direct adaptation of Newton's First Law of Motion, which states: Every object in a state of uniform motion tends to remain in that state of motion unless an external force is applied to it.
So for chartists identifying a trend and riding that trend until it reverses is the whole goal.
Yes, history repeat itself because human psychology does not change. As pointed out by Sigmund Freud, we human beings are essentially driven by greed and fear, pain and pleasure principle.
The chartists simply study these very fundamental human nature in studying charts which have been indentified and categorized over the last century to reflect certain pictures and appear on price charts.
Simply put, the chartist recognizes certain chart patterns in studying the past price action which they incorporate to predict future price movement.
The Technical Analysis approach is often criticized for the following cases:
The basis of self-fulfilling prophecy is that everyone watching the chart should react at the same time to the same price pattern formation that it begins to influence events.
Make no mistake that all the technicians watching chart may react at the same time to the same price pattern formation to cause only a slight price distortion in their direction. However, major bull and bear market can occur and be maintained when such market moves are justified by the law of supply and demand.
In fact, chart reading is a form of art. Even if all the technicians notice the same price pattern formation, they may not all act at the same time.
Some may react in anticipation of price pattern formation, some other may react only after price pattern formation is complete. Some may be very aggressive, while others may be conservative. Some may trade for short term purpose while others may trade for long term purposes.
Thus the possibility that all technicians may react at the same time can be ruled out.
Moreover, if all of the technicians and the systems started acting at the same time over the formation of same price pattern then either everyone would make money or everyone would loose money.
However, since trading is a zero sum game - for every winner there must be a looser, this would not be possible.
What is the real basis of using past price data to predict future? Can it be really validated?
This is really a challenging crticism. However, if we look into other method of forecasting, wheter be it weather or fundamental, both implement time series analysis -analysis performed based on a study of the past data.
All the concepts of technical analysis, which includes chart analysis is founded on the grounds of statistical concepts. That is to say, all the technical forecasting is not all absolute but they are probabilistic.
The basis of randwom walk theory is that past data is not a reliable indicator of future market movements. It is founded on the efficient market hypothesis, which claims that prices fluctutate randomly about the intrinsic value.
Randomness or "noise" seems to exist in a certain degree in all markets. But it will be unjust to claim all price fluctuation merely random or "noise" because charts demonstrate the presence of trends in a conspicuous manner.
In the uptrend illustrated, the chart demonstrates what happened yesterday does effect the price movement today or tomorrow or else any such trend should be non existent.
It's fair to say that any charts look just as random as the proponets of random walk theory claims unless they are studied meticulously.
To make another case, those who understand electrocardiogram chart, it may mean life and death but for those who do not understand it, it may mean merely a ugly printout.
As one become more skilled at reading chart, it become more meaningful and less random.