As an approach to investment analysis, technical analysis is radically different from fundamental analysis. Technical analysts don’t evaluate a large number of fundamental factors relating to the company, the industry and the economy. Instead they analyze market generated data like prices and volumes to determine the future direction of price movement.
The technical approach is the oldest approach to equity investment dating back to the late 19th Century. Thanks to its intuitive appeal, it is widely used. However, its validity has been severely challenged in recent decades.
The basics premises of technical analysis are as follows: (1) Bring minor deviations, stock prices tend to move in fairly persistent trends. (2) Shifts in demand and supply bring about changes in trends (3) Irrespective of why they occur shifts in demand and supply and be detected with the help of charts of market action. (4) Because of the persistence of trends and patterns, analysis of past market data can be used to predict future price behavior.
Technical analysts use a variety of charting techniques. The most popular ones seem to be the Dow theory, bar and line charts the point and figure chart, the moving average line and the relative strength line.
The basic concepts underlying chart analysis are (1) persistence of trends, (2) relationship between volume and trend, and (3) resistance and support levels.
The Dow theory is perhaps the oldest and best known theory of technical analysis. In the words of Charles Dow: The market is always in the short swing, running from weeks to a month or more the third is the main movement covering at least four years in its duration.
The bar chart, one of the simplest and, most commonly used tools of technical analysis, depicts the daily price change along with the closing prices. In addition it may show the daily volume of transaction. A line chart, a simplification over the bar chart, shows the line connecting successive closing prices. Technical analysts believe that certain formations or patterns observed on the bar chart and line chart have predictive value. The important formations are: head and shoulders top pattern, inverse head and shoulders top pattern triangle or coil formation, flags and pennants formation, double top formation and double bottom formation.
More complex than a bar chart a point and figure chart (PFC) condenses the recording of price changes by eliminating the time scale and small changes.
To identify trends, analysts use moving averages analysis.
The relative strength analysis is based on the assumptions that prices of some securities rise rapidly during the bull phase but fall slowly during the bear phase in relation to the market as a whole.
In addition to the chart, which forms the mainstay of technical analysis, technicians also use certain indicators – breadth indicators and market sentiment indicators – to gauge the overall market situation. The popular breadth indicators are the advance decline line, new highs and lows and volume. The popular sentiment indicators are the short interest ratio, mutual fund liquidity, put/call ratio, and Trin statistic.
A number of ethnical trading rules are in vogue. To assess whether a technical trading rule is valid, you have to at a minimum ask the following questions: Does the trading rule produce excess returns after dusting for risk? Does the trading rule produce excess returns after adjusting for transaction and other costs (like taxes)? How consistent is the performance of the trading rule? Is the trading rule valid outside the sample?
Technical analysis appears to be a highly controversial approach to security analysis. It has its ardent votaries as well as severe critics.
In a rational well-ordered and efficient market, technical analysis is a worthless exercise. However given the imperfections, inefficiencies and irrationalities that are characteristics real world markets, technical analysis can be helpful. But it is unlikely to be of great value. Hence, it may be used albeit to a limited extent, in conjunction with fundamental analysis to guide investment decision making.