What Is Technical Analysis and Why Use It?

What Is Technical Analysis and Why Use It?
By Colin Nicholson

Most people start off accepting the basic premise of what is called "fundamental analysis", that a financial security (share, option, warrant, futures contract) has what is called an "intrinsic value". However, a little experience in the markets soon shows that this intrinsic value is difficult to determine and that expert analysts are often in disagreement about it. The reason is that such valuation is very subjective. Anyone with any experience with takeovers will know about "independent expert" valuations that vary wildly.

A more important problem is that the market often prices financial securities at prices at variance with commonly agreed value. While it can be shown that there is a long term correlation between value and market price, in the short term (months or years), market prices differ substantially from value. So, while one can profit by buying securities that the market is undervaluing and holding them until the market adjusts, our capital could be better employed elsewhere in the interim. In other words, there is a timing problem.

Instead of trying to determine the underlying value of a security, technical analysis seeks to identify when the market actually begins to identify mispricing in the market. Once this happens, price tends to rectify the situation. However, this does not happen over night and instead takes place gradually, forming a trend on a graph of market price. What the technical trader tries to do is enter once the adjustment process is under way and exit once it has finished.

There are two common misconceptions about technical analysis. The first is that they try to forecast the future. Indeed, some analysts do try to do that. However, they are no more successful than economists in general and those employed by governments in particular. However, those who trade successfully using technical analysis do not try to forecast prices. Instead, they restrict their endeavours to identifying trends. This is much easier to do and is a much more profitable approach to the markets.

The second common misconception is that it is necessary to identify the top and bottom prices in the trend. Again, there are some technical analysts who try to do this, with conspicuous lack of consistent success. Those technical traders who are consistently successful in the markets enter the trend once it has clearly started and exit once it has clearly ended.

How does the technical analyst do this? It is done by studying the market for the financial security itself. This primarily means studying price, but includes the volume of trading. In some derivatives markets (principally futures and options), the open interest, or number of contracts open at any time, is also used.

This is because the technical analyst understands that there is a difference between the value of a company if you purchased all of it in a takeover and the value of its shares. The value of the shares is driven not only by the underlying value of the company, but also by the needs and expectations of shareholders and potential shareholders. Two simple examples are the person who must raise cash in a hurry, who will accept a lower price because of time constraints and the fund manager caught short of a stock that starts to move, who will pay a higher price because he cannot afford to let his competitors do better in the fund performance ratings


Introduction

One of the fundamental weaknesses of human beings is our desire to 'get rich quick'. On the one hand, our head tells us to be cautious. We know that there are few genuine rewards to be gained in life without hard work. On the other hand, something inside us makes us want to chase the quick big bucks.

Wherever there is a desire to make 'easy' money, there are unscrupulous people who will relieve greedy people of their hard-earned money. Collectively, these people comprise the 'temple of boom'!

One key to being able to survive and prosper is awareness. We are less likely to make crazy decisions based on greed or fear if we are aware of how human beings behave when influenced by crowd behaviour, and how this behaviour tends to be consistent over time. We are also less likely to become the victim of con artists if we have a basic awareness of the techniques they use to lure their victims.

The second key is discipline - the discipline to say "no", or "no, not until I have researched this more thoroughly". Awareness and discipline are the keys to surviving and prospering as a trader or investor in the temple of boom.

Crowd Psychology

The reason we use technical analysis (and fundamental analysis) is because history repeats. Human beings are today as much the victims of the emotions of greed and fear as they were centuries ago.

"But", you say, "… it is different this time. We live in a technologically advanced age." If you believe that it is different today, and that we are too sophisticated to become the victims of speculative manias, you would probably agree with the following quotation from Professor Irving Fisher, formerly of Yale University.

"We are living in an age of increasing prosperity and consequently increasing earning power of corporations and individuals. This is due in large measure to mass production and inventions such as the world never before has witnessed... This is a new and tremendously powerful factor... and one which never before existed."

Professor Irving Fisher was an economist and stock market authority. He also stated, when asked if he thought the market was too high, that he thought the market had reached a permanent plateau of prosperity.

Sadly for Professor Fisher, his statement was made in 1929 - at the time of the market top and just prior to the crash. The Dow subsequently lost some 90 percent of its value as the market fell into its final bottom in 1932.

The experts thought it was different in 1932. It is different every time - unless one studies a chart and notes the parabolic curve and blow off top that occurs at the end.

As individuals, we tend to behave in an intelligent, controlled manner - at least most of the time. When we become members of a crowd, however, our behaviour can change quite considerably.

Human beings become members of a crowd and follow the crowd because:
• Being a member of a crowd gives them a feeling of security.
• Following a strong leader allows them to feel reassured.
• Doing what others do helps to combat a fear of uncertainty.
• They have felt secure being members of different groups all of their lives, and hence are conditioned to wanting to become a member of a group.
As members of a crowd, we tend to follow the crowd leader, and to trust the judgement of the crowd leader more than our own judgement. In the case of trading, the crowd leader becomes 'price'. Members of crowds tend to respond only to very obvious changes (such as a market crash), and not slow, subtle changes, such as a bull market slowly making a topping pattern and turning downward. They also become more emotional and impulsive - which is not a desirable characteristic of a trader.

An understanding of crowd behaviour will help you to understand how traders become mesmerised by roaring bull markets, and how they fail to see the clear warning signs that the market is becoming dangerously overbought. Such an understanding can make you, and save you, a great deal of money!

An understanding of how individuals behave when they are a member of a crowd is very important for a trader, as there are times when a trader must do the exact opposite to what the crowd is doing. In trading, this understanding comes from studying the theory of contrary opinion.

To be a professional trader, you need to be able to analyse what 'the crowd' is doing at any one time, and be prepared to do the opposite should your trading system give you a signal to do so. At the very least, you should exercise the utmost care when you observe extreme crowd behaviour. The crowd's collective judgment is correct in the middle of market moves. It is wrong at market tops and bottoms.