INTRODUCTION
Before beginning a study of the actual techniques and tools used in
technical analysis, it is necessary first to define what technical
analysis is, to discuss the philosophical premises on which it is based,
to draw some clear distinctions between technical and fundamental
analysis and, finally, to address a couple of criticisms frequently
raised against the technical approach.
The author’s strong belief is that a full appreciation of the
technical approach must begin with a clear understanding of what
technical analysis claims to be able to do and, maybe even more
importantly, the philosophy or rationale on which it bases those
claims.
First, let’s define the subject. Technical analysis is the study of
market action, primarily through the use of charts, for the purpose of
forecasting future price trends. The term “market action” includes the
three principal sources of information available to the techni-cian—price, volume, and open interest. (Open interest is used only in
futures and options.) The term “price action,” which is often used,
seems too narrow because most technicians include volume and open
interest as an integral part of their market analysis. With this
distinction made, the terms “price action” and “market action” are
used interchangeably throughout the remainder of this discussion.
PHILOSOPHY OR RATIONALE
There are three premises on which the technical approach is based:
1. Market action discounts everything.
2. Prices move in trends.
3. History repeats itself.
Market Action Discounts Everything
The statement “market action discounts everything” forms what is
probably the cornerstone of technical analysis. Unless the full
significance of this first premise is fully understood and accepted,
nothing else that follows makes much sense. The technician believes
that anything that can possibly affect the price—fundamentally,
politically, psychologically, or otherwise—is actually reflected in the
price of that market. It follows, therefore, that a study of price action
is all that is required. While this claim may seem presumptuous, it is
hard to disagree with if one takes the time to consider its true
meaning.
All the technician is really claiming is that price action should
reflect shifts in supply and demand. If demand exceeds supply, prices
should rise. If supply exceeds demand, prices should fall. This action
is the basis of all economic and fundamental forecasting. The
technician then turns this statement around to arrive at the conclusion
that if prices are rising, for whatever the specific reasons, demand
must exceed supply and the fundamentals must be bullish. If prices
fall, the fundamen-tals must be bearish. If this last comment about fundamentals seems
surprising in the context of a discussion of technical analysis, it
shouldn’t.
After all, the technician is indirectly studying
fundamentals. Most technicians would probably agree that it is the
underlying forces of supply and demand, the economic fundamentals
of a market, that cause bull and bear markets. The charts do not in
themselves cause markets to move up or down. They simply reflect
the bullish or bearish psychology of the marketplace.
As a rule, chartists do not concern themselves with the reasons
why prices rise or fall. Very often, in the early stages of a price trend
or at critical turning points, no one seems to know exactly why a
market is performing a certain way. While the technical approach
may sometimes seem overly simplistic in its claims, the logic behind
this first premise—that markets discount everything—becomes more
compelling the more market experience one gains.
It follows then that
if everything that affects market price is ultimately reflected in
market price, then the study of that market price is all that is
necessary. By studying price charts and a host of supporting technical
indicators, the chartist in effect lets the market tell him or her which
way it is most likely to go. The chartist does not necessarily try to
outsmart or outguess the market. All of the technical tools discussed
later on are simply techniques used to aid the chartist in the process
of studying market action. The chartist knows there are reasons why
markets go up or down. He or she just doesn’t believe that knowing
what those reasons are is necessary in the forecasting process.
Prices Move in Trends
The concept of trend is absolutely essential to the technical approach.
Here again, unless one accepts the premise that markets do in fact
trend, there’s no point in reading any further. The whole purpose of
charting the price action of a market is to identify trends in early
stages of their development for the purpose of trading in the direction
of those trends. In fact, most of the techniques used in this approach
are trend-following in nature, meaning that their intent is to identify
and follow existing trends. (See Figure 1.1.)