Technical Analysis

By Sadra Moharami

In finance, technical analysis is an analysis methodology for analyzing and

forecasting the direction of prices through the study of past market data, primarily
price and volume. As a type of active management, it stands in contradiction to much
of modern portfolio theory. The efficacy of technical analysis is disputed by the
efficient-market hypothesis, which states that stock market prices are essentially
unpredictable, and research on whether technical analysis offers any benefit has
produced mixed results. It is distinguished from fundamental analysis, which considers a company's financial
statements, health, and the overall state of the market and economy.

History
The principles of technical analysis are derived from centuries of financial market data, with early precursors
appearing in the 17th century through Joseph de la Vega's accounts of Dutch markets. In 18th-century Asia,
Homma Munehisa developed a method that later evolved into modern candlestick charting techniques.

The foundation of Western technical analysis was significantly advanced by Charles Dow (1851–1902), a
journalist who systematically compiled and analyzed American stock market data. His work, published in Wall
Street Journal editorials, introduced the concept of "Dow theory," suggesting that identifiable patterns and
business cycles exist in market data. Dow himself, however, never promoted his ideas as a direct trading strategy.
The discipline was further developed in the 1920s and 1930s by Richard W. Schabacker, who built upon the
work of Dow and William Peter Hamilton. A major milestone was reached in 1948 with the publication
of Technical Analysis of Stock Trends by Robert D. Edwards and John Magee, a work that remains a cornerstone
of the field, focusing on trend analysis and chart patterns. In its early days, technical analysis was almost
exclusively chart-based due to limited computational power for statistical analysis.

Other early 20th-century pioneers who contributed distinct techniques include Ralph Nelson Elliott, William
Delbert Gann, and Richard Wyckoff. More recently, the emergence of behavioral finance has led to integrations
with technical analysis, exemplified by Paul V. Azzopardi's coining of the term "Behavioral Technical Analysis."

General Description
Technical analysis is a trading discipline distinct from fundamental analysis. While fundamental analysts
examine a company's intrinsic value through earnings, dividends, and new products, technical analysts focus
solely on price action and market trends to identify trading opportunities. The primary tool for this is the use of
charts.

Technicians employ a wide array of methods to analyze these charts. They search for archetypal price patterns,
such as the head and shoulders or double top for reversals, and continuation patterns like flags, pennants, and the
cup and handle. They also study technical indicators, which are often mathematical transformations of price and
volume data. These include tools like moving averages, the Relative Strength Index (RSI), and the MACD, which
help assess the strength and probability of a trend's continuation.
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Beyond price, analysts examine market sentiment using indicators such as put/call ratios, bull/bear ratios, and
short interest. The field encompasses many specific techniques, with some of the most well-known being
Candlestick analysis, Dow theory, and Elliott Wave theory. While some traders adhere strictly to one technique,
many combine elements from several. Furthermore, approaches can range from subjective judgment, where an
analyst interprets which pattern is forming, to a strictly mechanical and systematic application of trading rules.

Comparison with fundamental analysis

This passage contrasts fundamental analysis—which evaluates economic, corporate, and geopolitical factors
(like financial reports or global warming) to understand market prices—with technical analysis. It notes that
pure technical analysts believe all fundamental factors are already reflected in the price. The core goal of
technical analysis is to uncover future trends using technical indicators. The text concludes by stating that while
neither method is perfect, traders may use one or a combination of both to make decisions.

Comparison with quantitative analysis

The text explains that the relationship between technical analysis and quantitative analysis is unclear and
debated. Unlike the clear distinction with fundamental analysis, some experts see technical and quantitative
analysis as very similar, while others, like Paul Wilmott, sharply separate them, viewing technical analysis as
simple "charting" with limited predictive value.

Principles
A core principle of technical analysis is that a market's price reflects all relevant information impacting that
market. A technical analyst therefore looks at the history of a security or commodity's trading pattern rather than
external drivers such as economic, fundamental and news events. It is believed that price action tends to repeat
itself due to the collective, patterned behavior of investors. Hence technical analysis focuses on identifiable price
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
important to understand what investors think of that information, known and perceived.

Prices move in trends

Technical analysts believe that prices trend directionally, i.e., up, down, or sideways (flat) or some combination.
The basic definition of a price trend was originally 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. In other words, each time the stock moved 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 does not 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.
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History tends to repeat itself

Technical analysts believe that investors collectively repeat the behavior of the investors who preceded them. To
a technician, the emotions in the market may be irrational, but they exist. Because investor behavior repeats itself
so often, technicians believe that recognizable (and predictable) price patterns will develop on a chart.
Recognition of these patterns can allow the technician to select trades that have a higher probability of success.

Technical analysis is not limited to charting, but it always considers price trends. For example, many technicians
monitor surveys of investor sentiment. These surveys gauge the market sentiment of 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 investing.

Systematic Trading
Neural networks
Artificial Neural Networks (ANNs) are AI systems inspired by biological brains that have become increasingly
popular since the 1990s. Their key strength is the ability to learn complex patterns in data and model any input-
output relationship, making them "universal function approximators."

In financial trading, this means ANNs can automatically generate market signals using technical and fundamental
data, eliminating the need for manual chart analysis or rigid rules. Studies show that ANN-based trading systems
often significantly outperform both simple buy-hold strategies and traditional linear analysis methods.

Although their complex, mathematical nature initially confined them to academic research, the recent
development of more user-friendly software has made this powerful technology increasingly accessible to
traders.

Backtesting/Hindcasting
Systematic trading is most often employed after testing an investment strategy on historic data. This is known as
backtesting (or hindcasting). Backtesting is most often performed for technical indicators combined with
volatility but can be applied to most investment strategies (e.g. fundamental analysis). While traditional
backtesting was done by hand, this was usually only performed on human-selected stocks, and was thus prone
to prior knowledge in stock selection. With the advent of computers, backtesting can be performed on entire
exchanges over decades of historic data in very short amounts of time.
The use of computers does have its drawbacks, being limited to algorithms that a computer can perform. Several
trading strategies rely on human interpretation, and are unsuitable for computer processing. Only technical
indicators which are entirely algorithmic can be programmed for computerized automated backtesting.