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 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 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:
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 a period of 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—no statistical corroboration of the predictive value of women's hemlines, however. 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.
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 their charts.
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 he will be right more often than he will be wrong.
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.