Technical Analysis (TA)

Technical analysis is the use of past prices and trading volume of financial instruments to forecast future prices; economic and fundamental analysis is outside of its purview. A technical analyst believes that all relevant information has already been accounted for in the current market. Technical analysis can be used for most kinds of financial markets that use public exchanges and where there is sufficient volume of trading, such as the exchanges for stocks, futures and currencies. However, it is not very useful for commodity markets, which are much more strongly driven by fundamentals.

So why does technical analysis discount fundamental analysis? Because the technical analyst believes that the main movers of the market are the greed and fear of uninformed investors. Thus, these investors are affected by what the market is doing, and their reactions seem to follow patterns that tend to repeat themselves over time. These patterns can be studied best through the use of charts, which graphs prices and volume over time. Technical analysis is premised on the following:

  1. Market value is determined by the equilibrium of supply and demand.
  2. Both rational and irrational factors determine supply and demand.
  3. Although there are fluctuations, market prices trend up or down for a variable, but usually, extended time.
  4. Changes in the trend result from changes in supply and demand.
    1. The converse is not necessarily true, since changes in supply and demand are also necessary to continue a trend; otherwise the market price would remain the same.
  5. Regardless of their cause, trend changes can be detected in charts of prices and volume plotted over time.
  6. Some chart patterns recur frequently; hence, they are useful in trading decisions based on a probability that a pattern will repeat itself.

Trends and Indicators

The primary pattern followed by technical analysts is the trend, which is the direction that market prices or individual security prices are moving. The primary trend is the main direction of the market over time—in many cases, for months. However, within the primary trend are many secondary and tertiary trends, which reflects the imbalance between supply and demand over shorter time frames. These minor trends also form patterns within the primary trend. In fact, many of the patterns have a fractal nature where the smaller patterns and the larger patterns have the same general shape but extend over different time periods, such as over the day, week, month, or even years.

Another major tool of the technical analyst is the use of market ratios, or market indicators, and other statistics, such as odd-lot trading, short-sale ratios, and volume of trading that indicate market sentiment, which is the optimism or pessimism felt by most of the uninformed traders.

Technical analysts also use rules, which have accumulated over the years as traders noticed the juxtaposition of events that seem to have a strong correlation, and, thus, predictive power. These rules have been codified in an attempt to capture relationships that seem to be persistent, and sometimes, there's even an attempt to "explain" the relationship. Thus, there is a rule that "As January goes, so goes the year." Another old rule was that the market went up or down along with the hemlines of women's dresses, and that if a team, either a current member or former member, of the National Football Conference wins the Super Bowl, then it will be a good year for the stock market. The latter rule has been correct 82% of the time — there is no statistical corroboration of the predictive value of women's hemlines, however. It probably wouldn't be wise to bet one's fortune on these rules!

Some rules do have a strong statistical correlation. One such rule is the presidential third-year rule, which states that the stock market is always up on the 3rd year of a president's term. Since 1945, these years have averaged returns of 17.4%—twice as high as the other years of the presidential terms. In fact, the S&P 500 has never posted a loss during a term's 3rd year, and was up 23% in 2003, the 3rd year of George W. Bush's 3rd year. However, the market did not do as well in the 3rd year of Barack Obama's 1st term, with the stock market up only a little from the beginning of the year to year-end.

Short History of Technical Analysis

Technical analysis began in the late 1800's when there was little else to guide one's trading decisions other than market data. There was little information on individual companies or even the economy, and so, some traders tried to predict stock prices by observing the overall stock market, since most of the time, the price movements of individual stocks are determined by the movement of the market as a whole.

The Dow theory was one of the earliest attempts at technical analysis of the markets. Charles H. Dow, one of the founders of Dow Jones observed that the market basically follows a primary trend that is superposed on the many smaller movements of the market until a reversal occurs. Charles Dow developed 2 indexes that helped his analysis of the market: the Industrial Average, which would later be called the Dow Jones Industrial Average (DJIA) and the Railroad Average, which was based on 10 railroads and 2 industrial stocks. Railroads were far more important in Dow's day than they are today, which is why railroads constituted most of what would eventually become the Dow Jones Transportation Average.

The Dow theory used both the DJIA and the Railroad Average to confirm a reversal. If both averages change direction, then this is treated as a confirmation of the reversal. The major drawback to the Dow theory is that it has no predictive value—there is no guidance as to how long the trend will last or when the reversal will occur. That there are primary trends in major market indexes is easily observable in the charts.

The Objectives of Technical Analysis

The main objectives of technical analysis are to be able to profit from trading by observing market patterns and statistics, to know when to enter and exit a market, especially when it starts to shift, and to not let emotions influence trading decisions.

Because technical analysis is based on the emotional trading of the uninformed masses, it is only effective in auction markets, where many buyers and sellers converge to 1 point—be it the floor of an exchange or a website—where the public price is determined by the highest bid price and the lowest ask price.

Although technical analysis takes some of the emotion out of trading by relying on specific signals, it does require intuition and interpretation, since technical information is rarely unambiguous. Patterns will rarely be the exact shape that the trader is looking for and the value of ratios will often border on blurry edges. Furthermore, even if the pattern or ratio is unambiguous, it doesn't mean that the trader will profit, even if the trades are executed flawlessly, because almost all of the predictive value of technical analysis is based on probabilities. Furthermore, these probabilities cannot be determined precisely, because there is a great deal of interpretation in technical analysis, so differing probabilities may be due to different interpretations. Oftentimes, rules have to be changed, because what worked before no longer works. Hence, there will be times—maybe many times—when the expected doesn't happen. The primary hope of the technical analyst is that being right will happen more often than being wrong.

Does Technical Analysis Work?

There are many websites that offer extensive information on technical analysis, and websites that publish market data also offer many tools used in technical analysis.

The weak form of the efficient market hypothesis hypothecates that since past market information provides no clues about the future market, and that trades exhibit a random walk, making market prices unpredictable, technical analysis can't work. While there are many arguments for and against technical analysis, stock market bubbles and their aftermath do seem to support the idea that market sentiment moves the market at least significantly, if not more than fundamental data.

So, does technical analysis work? It seems to work for some people, but the question you have to ask yourself is, is it worth the amount of time that you will spend analyzing prices, volumes, and other market data? Will you enjoy such detailed analysis? Will the market consume your consciousness? Will your profits exceed your losses? While I have read about people, such as Warren Buffett, becoming rich by their fundamental analysis of individual companies and their prospects, I have never read about anybody becoming rich through technical analysis. This is not to say that it doesn't work, but it may not work as well as other methods.

Furthermore, many technical analysis proponents seem to make more money selling their system than actually trading the market. One of the most famous examples is Ralph Nelson Elliott who made bundles of money giving talks and selling newsletters, touting his Elliott Wave Theory. But there is little evidence that he made a lot of money actually using his system to trade stocks!


Program Trading Using Quantitative Strategies

Your Portfolio on Autopilot -

Program trading is allowing the computer to trade stocks in your account according to some algorithm that someone has conceived to hopefully make money automatically. Naturally, program trading is predicated on the fundament of technical analysis—that profits can be made simply by observing patterns in market activity that can forecast future price movements. The most sophisticated of these can trade stocks, options, and currencies in the same portfolio.

Historically, program trading was restricted to big investors, but several brokerages are now offering program trading software for small investors. TD Ameritrade Holding Corp. is planning on providing automated trading to its customers very soon. Fidelity Investments provides Wealth Lab Pro software where investors can program their own algorithms based on historical data and 600 market indicators, or choose from about 1,000 quantitative strategies already programmed into the software. TradeStation claims that investor interest is high and growing. Interactive Brokers provides forums where program traders can exchange ideas for new algorithms, or provide their ideas to new investors. Some brokerages are offering a less risky strategy by simply sending alerts based on preset market parameters. Most brokerages prudently allow only active investors with a substantial minimum in their accounts to program trade.

Naturally, the brokerages like program trading, because computers trade without worrying about how much money the trades are costing the investor in brokerage commissions. Other risks to the investor include the possibility that the trading algorithm will have significant flaws that may only come up in unusual market conditions, especially since it is impossible to test this kind of software under every possible scenario, but these flaws could cost the investor a significant amount of money, for which the investor will be legally liable. This is especially true for new algorithms being submitted by other investors in forums.

Alas, program trading, like technical analysis, and throwing darts at a list of securities, only works some of the time for the lucky few. Since program trading doesn't take into account company fundamentals, it is, by necessity, based on historical patterns, and if one can profit by simply repeating past strategies, then we can all be rich by simply following the most successful algorithms. But this can't work, because trading doesn't create new wealth—it only transfers wealth from 1 trader to another, so in any given trade, somebody wins, but somebody else has to lose, although it may not be immediately evident who is who.

There is one group, however, who will be consistent winners with program trading, and that's the brokerages, as they reap the increased commission income that comes with program trading.