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"Technical analysis is the study of market action, primarily through the use of Charts , for the purpose of forecasting future price trends.".John J. Murphy, ''Technical Analysis of the Futures Markets'' (New York Institute of Finance, 1986), page 1. In its purest form, technical analysis considers only the actual price behavior of the market or instrument, based on the premise that price reflects all relevant factors before an investor becomes aware of them through other channels. Technical analysis is widely used among traders and financial professionals, and some studies say its use is more widespread than is "fundamental" analysis in the chapter 11, pp. 113-115. Academics such as Eugene Fama say the evidence for technical analysis is sparse and is refuted by the Efficient Market Hypothesis ,Fama, Eugene (May 1970). [http://www.e-m-h.org/Fama70.pdf "Efficient Capital Markets: A Review of Theory and Empirical Work,"] ''The Journal of Finance'', v. 25 (2), pp. 383-417.,Griffioen, '' Technical Analysis in Financial Markets '' yet some Federal Reserve and academic studies include evidence that supports technical analysis.Brock, William, Josef Lakonishok and Blake Lebaron (1992). "Simple Technical Trading Rules and the Stochastic Properties of Stock Returns," ''The Journal of Finance'', 47(5), pp. 1731–1764.Osler, Karen (July 2000). "Support for Resistance: Technical Analysis and Intraday Exchange Rates," FRBNY Economic Policy Review ( abstract and paper here ).Neely, Christopher J., and Paul A. Weller (2001). "Technical analysis and Central Bank Intervention," ''Journal of International Money and Finance'', 20 (7), 949–70 ( abstract and paper here ). MIT finance professor Andrew Lo argues that "several academic studies suggest that…technical analysis may well be an effective means for extracting useful information from market prices."Lo, Andrew W., Harry Mamaysky and Jiang Wang (2000). "Foundations of Technical Analysis: Computational Algorithms, Statistical Inference, and Empirical Implementation," ''Journal of Finance'', v. 55 ( abstract and paper here ), pp. 1705-1765. Burton Malkiel argues, "Technical analysis is anathema to the academic world." Burton Malkiel , '' A Random Walk Down Wall Street '' pp. 139, 165 GENERAL DESCRIPTION Technical analysts (or technicians) identify non-random price patterns and trends in financial markets and attempt to exploit those patterns John J. Murphy, ''Technical Analysis of the Financial Markets'' (New York Institute of Finance, 1999), pages 1-5,24-31. While technicians use various methods and tools, the study of price charts is primary. Technicians especially search for archetypal patterns, such as the well-known head and shoulders reversal pattern, and also study such indicators as Price , Volume , and Moving Average s of the price. Many technical analysts also follow indicators of investor psychology ( Market Sentiment ). Technicians seek to forecast price movements such that large gains from successful trades exceed more numerous but smaller losing trades, producing positive returns in the long run through proper Risk control and Money Management . There are several schools of technical analysis. Adherents of different schools (for example, Candlestick Chart ing, Dow Theory , and Elliott Wave Theory ) may ignore the other approaches, yet many traders combine elements from more than one school. Technical analysts use judgment gained from experience to decide which pattern a particular instrument reflects at a given time, and what the interpretation of that pattern should be. Technical analysts may disagree among themselves over the interpretation of a given chart. Technical analysis is frequently contrasted with '' Fundamental Analysis '', the study of Economic factors that some analysts say can influence prices in financial markets. Pure technical analysis holds that prices already reflect all such influences before investors are aware of them, hence the study of price action alone. Some traders use technical or fundamental analysis exclusively, while others use both types to make trading decisions. HISTORY The principles of technical analysis derive from the observation of Financial Market s over hundreds of years. The oldest known example of technical analysis was a method used by Japan ese traders as early as the 18th Century , which evolved into the use of Candlestick Techniques , and is today a main charting tool.1Nison, Steve (1994). Beyond Candlesticks: New Japanese Charting Techniques Revealed, John Wiley and Sons, p. 14. ISBN 047100720X Dow Theory is based on the collected writings of Dow Jones co-founder and editor Charles Dow , and inspired the use and development of modern technical analysis from the end of the 19th Century . Modern technical analysis considers Dow Theory its cornerstone.2 Many more technical tools and theories have been developed and enhanced in recent decades, with an increasing emphasis on Computer -assisted techniques. PRINCIPLES OF TECHNICAL ANALYSIS Technicians say that a market's price reflects all relevant information, so their analysis looks more at "internals" than at "externals" such as news events. Price action also tends to repeat itself because investors collectively tend toward patterned behavior -- hence technicians' focus on identifiable trends and conditions. Market action discounts everything Based on the premise that all relevant information is already reflected by prices, technical analysts believe it is redundant to do Fundamental Analysis -- they say news and news events do not significantly influence price, and cite supporting research such as the study by Cutler, Poterba, and Summers titled "What Moves Stock Prices?" On most of the sizable return days market moves …the information that the press cites as the cause of the market move is not particularly important. Press reports on adjacent days also fail to reveal any convincing accounts of why future profits or discount rates might have changed. Our inability to identify the fundamental shocks that accounted for these significant market moves is difficult to reconcile with the view that such shocks account for most of the variation in stock returns. David M. Cutler, James M. Poterba, Lawrence H. Summers, " What Moves Stock Prices? ", NBER Working Paper #2538 (March 1988), pp 13-14. Prices move in trends See Also: Market Trend Technical analysts believe that prices trend. Technicians say that markets trend up, down, or sideways (flat). This basic definition of price trends is the one put forward by Dow Theory. An example of a security that had an apparent trend is AOL from November 2001 through August 2002. A technical analyst or trend follower recognizing this trend would look for opportunities to sell this security. AOL consistently moves downward in price. Each time the stock rose, sellers would enter the market and sell the stock; hence the "zig-zag" movement in the price. The series of "lower highs" and "lower lows" is a tell tale sign of a stock in a down trend.Kahn, Michael N. (2006). ''Technical Analysis Plain and Simple: Charting the Markets in Your Language'', Financial Times Press, Upper Saddle River, New Jersey, p. 80. ISBN 0131345974. In other words, each time the stock edged lower, it fell below its previous relative low price. Each time the stock moved higher, it could not reach the level of its previous relative high price. Note that the sequence of lower lows and lower highs did not begin until August. Then AOL makes a low price that doesn't pierce the relative low set earlier in the month. Later in the same month, the stock makes a relative high equal to the most recent relative high. In this a technician sees strong indications that the down trend is at least pausing and possibly ending, and would likely stop actively selling the stock at that point. History tends to repeat itself Technical analysts believe that investors collectively repeat the behavior of the investors that preceded them. "Everyone wants in on the next Microsoft," "If this stock ever gets to $50 again, I will buy it," "This company's technology will revolutionize its industry, therefore this stock will skyrocket" -- these are all examples of investor sentiment repeating itself. To a technician, the emotions in the market may be irrational, but they exist. Because investor behavior does repeat itself so often, technicians believe that recognizable (and predictable) price patterns will develop on a chart. Technical analysis is not limited to charting, yet is always concerned with price trends. For example, many technicians monitor surveys of investor sentiment. These surveys gauge the attitude of market participants, specifically whether they are Bearish or Bullish . Technicians use these surveys to help determine whether a trend will continue or if a reversal could develop; they are most likely to anticipate a change when the surveys report extreme investor sentiment. Surveys that show overwhelming bullishness, for example, are evidence that an uptrend may reverse -- the premise being that if most investors are bullish they have already bought the market (anticipating higher prices). And because most investors ''are'' bullish and invested, one assumes that few buyers remain. This leaves more potential sellers than buyers, despite the bullish sentiment. This suggests that prices will trend down, and is an example of Contrarian trading. CRITICISM |
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