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Technical analysis

In finance, technical analysis is a security analysis methodology for forecasting the direction of prices through the study of past market data, primarily price and volume.^[1] Behavioral economics and quantitative analysis use many of the same tools of technical analysis,^[2]^[3]^[4]^[5] which, being an aspect of active management, stands in contradiction to much of modern portfolio theory. The efficacy of both technical and fundamental analysis is disputed by the efficient-market hypothesis which states that stock market prices are essentially unpredictable.^[6]

Principles of Technical analysis

Principles[edit]

Stock chart showing levels of support (4,5,6, 7, and 8) and resistance (1, 2, and 3); levels of resistance tend to become levels of support and vice versa.

A fundamental principle of technical analysis is that a market's price reflects all relevant information, so their analysis looks at the history of a security's trading pattern rather than external drivers such as economic, fundamental and news events. Therefore, price action tends to repeat itself due to investors collectively tending toward patterned behavior – hence technical analysis focuses on identifiable trends and conditions.^[28]^[29]

Market action discounts everything[edit]

Based on the premise that all relevant information is already reflected by prices, technical analysts believe it is important to understand what investors think of that information, known and perceived.

Prices move in trends[edit]

See also: Market trend

Technical analysts believe that prices trend directionally, i.e., up, down, or sideways (flat) or some combination. The basic definition of a price trend was originally put forward by Dow theory.^[10]

An example of a security that had an apparent trend is AOL from November 2001 through August 2002. A technical analyst or trend follower recognizing this trend would look for opportunities to sell this security. AOL consistently moves downward in price. Each time the stock rose, sellers would enter the market and sell the stock; hence the "zig-zag" movement in the price. The series of "lower highs" and "lower lows" is a tell tale sign of a stock in a down trend.^[30] In other words, each time the stock moved lower, it fell below its previous relative low price. Each time the stock moved higher, it could not reach the level of its previous relative high price.

Note that the sequence of lower lows and lower highs did not begin until August. Then AOL makes a low price that does not pierce the relative low set earlier in the month. Later in the same month, the stock makes a relative high equal to the most recent relative high. In this a technician sees strong indications that the down trend is at least pausing and possibly ending, and would likely stop actively selling the stock at that point.

History tends to repeat itself[edit]

Technical analysts believe that investors collectively repeat the behavior of the investors that preceded them. To a technician, the emotions in the market may be irrational, but they exist. Because investor behavior repeats itself so often, technicians believe that recognizable (and predictable) price patterns will develop on a chart.^[10] Recognition of these patterns can allow the technician to select trades that have a higher probability of success.^[31]

Technical analysis is not limited to charting, but it always considers price trends.^[1] For example, many technicians monitor surveys of investor sentiment. These surveys gauge the attitude of market participants, specifically whether they are bearish or bullish. Technicians use these surveys to help determine whether a trend will continue or if a reversal could develop; they are most likely to anticipate a change when the surveys report extreme investor sentiment^[32] Surveys that show overwhelming bullishness, for example, are evidence that an uptrend may reverse; the premise being that if most investors are bullish they have already bought the market (anticipating higher prices). And because most investors are bullish and invested, one assumes that few buyers remain. This leaves more potential sellers than buyers, despite the bullish sentiment. This suggests that prices will trend down, and is an example of contrarian trading.^[33]

Recently, Kim Man Lui, Lun Hu, and Keith C.C. Chan have suggested that there is statistical evidence of association relationships between some of the index composite stocks whereas there is no evidence for such a relationship between some index composite others. They show that the price behavior of these Hang Seng index composite stocks is easier to understand than that of the index.^[34]

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Wednesday, February 24, 2016

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