Technical analysis is a method of evaluating statistical trends in trading activity, typically involving price movement and volume. It is used to identify trading and investment opportunities.
How is technical analysis used?
- Professional analysts typically combine technical analysis with other research methods for a comprehensive approach.
- Retail traders rely solely on price charts and related statistics to make trading decisions.
- Practicing equity analysts rarely limit their research to fundamental or technical analysis alone.
Underlying assumptions of technical analysis
Charles Dow introduced the foundation of technical analysis through a series of editorials. His two core assumptions remain integral to the framework of technical analysis trading today.
- Prices reflect all known information, but market reactions can be delayed and irrational. This market inefficiency creates opportunities for technical analysis
- Even seemingly random price movements often follow identifiable patterns and trends that repeat over time.
The field of technical analysis developed based on Dow Theory. Professional analysts generally accept three basic assumptions:
1. Price Reflects Everything: Stock prices incorporate all relevant information, including fundamentals and market psychology, aligning with the Efficient Markets Hypothesis.
2. Price Follows Trends: Prices are more likely to continue a trend than move unpredictably, forming the basis for most trading strategies.
3. History Repeats: Market psychology drives repetitive price patterns, allowing chart analysis to identify trends.
Limitations of Technical Analysis
1. EMH Critique: According to the Efficient Market Hypothesis, historical price and volume data hold no actionable insights, as all information is already priced in.
2. Randomness: Prices may follow a random walk, making historical patterns unreliable.
3. Self-Fulfilling Prophecy: Technical analysis may work because collective trader behavior causes predicted movements, not because patterns inherently hold value.
