What is Technical Analysis?
Simply put, "Technical Analysis" is the forecasting of future investment price movements based on an examination of past price movements.
Like weather forecasting, investment technical analysis does not result in absolute predictions about the future. Instead, technical analysis can help investors anticipate what is “likely” to happen to prices over time.
Technical analysis uses a wide variety of charts that show price over time.
Technical analysis is applicable to stocks, indices, commodities, futures or any tradable instrument where the price is influenced by the forces of theoretical market supply and demand.
Current price movement (aka “market action”) refers to any combination of what happens between the market open or close, intraday highs and lows, and total trading volume for a given security over a chosen time frame.
The quantified time frame can be based on intraday (1-minute, 5-minutes, 10-minutes, 15-minutes, 30-minutes or hourly), daily, weekly or monthly price data and can be used as a prediction for a few hours or many years.
At Arrowhead Asset Management, we only watch daily, weekly, and monthly price data for our investment decisions.
Key Assumptions of Technical Analysis
Technical analysis is applicable to an investment where the price is only influenced by the forces of supply (sellers) and demand (buyers). In order to be successful, technical analysis makes three key assumptions about the "securities" that are being analyzed:
High Liquidity - Liquidity essentially means the combined buy and sell volume (# of shares). Heavily-traded stocks allow investors to trade quickly and easily, without a minority of investors dramatically changing the price of the stock.
- Below Average Fees and Charges - We also only invest in ETFs or other investments that are easily bought or sold and do not have gain-eroding hidden fees or charges.
- No Extreme News (noise!) - To be sure, technical analysis cannot predict extreme events, including business events such as a company's CEO dying unexpectedly, and/or political events such as a terrorist act or some bully leader attacking a vulnerable nation for its oil. When the forces of “extreme news” are influencing the price, technicians usually need to have to wait patiently until the investment's chart settles down and starts to reflect the “new normal” that results from such extreme news.
The Basis of Technical Analysis
Modern technical analysis works on three quatifiable assumptions:
The Price of a Security Accounts for Everything Good and Bad About the Investment
Investment Price Movements Are Not Totally Random - They Generally Represent "Factual" Supply and Demand
The “What Is Happening" Is More Important than the “Why It's Happening”
Price of a Security Reflects Everything
Technical analysts believe that the current price fully reflects all known information. Because all information is already reflected in the price, it represents the fair value, and should form the basis for analysis.
The market price of an investment reflects the sum knowledge of all participants, including traders, investors, portfolio managers, analysts, market strategist, technical analysts, fundamental analysts and many others.
It would be folly to disagree with the price set by such an impressive array of people with such professional expertise.
Technical analysis utilizes the information captured by the price to interpret what the market is saying with the purpose of forming a view on the future.
Prices Movements are not "Random"
Most technicians agree that prices are always in an upward or downward trend.
However, most technicians also acknowledge that there are periods when prices do not trend. If prices were always random, it would be extremely difficult to make money using technical analysis.
An investment technician believe that it is possible to identify an investment's trend, invest or trade based on the trend and make money as the trend unfolds.
Because technical analysis can be applied to many different time frames, it is possible to spot both short-term and long-term trends.
"What" is More Important than "Why"
The price of an investment is the end result of the battle between the forces of supply and demand for the company's stock (or the Fund's daily price). The objective of technical analysis is to forecast the direction of the future price. By focusing on price and only price, technical analysis represents a direct approach.
Fundamental analysis is concerned with why the price of an investment is what it is. For technical analysts, the why portion of the equation is too broad and many times the fundamental reasons given are highly suspect.
Technicians believe it is best to concentrate on what the price is and rarely on why the price is where it is. Why did the price go up? It is simple, more buyers (demand) than sellers (supply). After all, the value of any asset is only what someone is willing to pay for it. Who needs to know why?
General Steps to Technical Evaluation
Many market technicians employ a top-down approach that begins with broad-based macro analysis. The larger parts are then broken down to base the final step on a more focused/micro perspective. Such an analysis might involve one, two, or all three steps below:
Broad market analysis through the major indices such as the S&P 500, Dow Industrials, NASDAQ and NYSE Composite.
Sector analysis to identify the strongest and weakest groups within the broader market.
Individual stock analysis to identify the strongest and weakest stocks within select groups.
The beauty of technical analysis lies in its versatility.
Because the principles of technical analysis are universally applicable, it does not matter if the time frame is 2 days or 2 years. It also does not matter if it involves a individual stock, an ETF, a market index or commodity. The technical principles of money flow, price support, price resistance, price trend, price trading range over time (and other aspects) can be applied to any chart analysis.
Technical analysis is by no means a panacea. But investment success requires serious study, dedication, and an open mind. Technical analysis expertise inceases our investment success rate substantially.
At Arrowhead Asset Management, we use technical analysis to try and take major risk out of our investment decisions. At least for our "buy" decision, It works 80% to 90% of the time.
"Sell" decisions are a little more complicated and beyond the scope of this article. Just know that "greed" can be a major problem for timely investment sell competence.