Most technical analysis depends on the efficient market hypothesis in that technical analysis assumes that a security’s price already reflects all publicly-available information and instead focuses on the analysis (often statistical) of price movements. After all, in an efficient market, you can’t gain an advantage concerning yourself with fundamental factors (and psychological ones) that are already baked into the price. While technical analysts live in a complicated world, the basic idea is simple: Supply and demand in the market determine prices. Technical analysis, then, attempts to understand the market sentiment behind price trends rather than studying a security’s fundamental characteristics. In addition to price movements, technical analysts are very concerned with volume.
A fundamental assumption of technical analysis is that trends exist in security prices. Think of this as a law of inertia for stock prices: An object in motion will continue to remain in motion unless acted on by some force. As with physics, stocks will continue to move in the same direction with the same velocity (price volatility) until something changes. The physics analogy breaks down however when we consider the magnitude of price movements.
Unlike asteroids and comets, stocks are tethered to the mean with a huge, invisible rubber band. When a stock price declines very far very rapidly, it is said to be oversold (there are more sellers than buyers, so the laws of supply and demand kick in and lower the stock’s price). When a stock’s price rises dramatically over a short period, it is said to be overbought (there are more buyers than sellers and supply and demand dictates the price rise). The basic strategy of the technical trader is to buy oversold securities and sell overbought ones. The timing of buying and selling is dictated to a large degree by technical indicators (which are also called signals).
A trend in technical analysis isn’t much different than the everyday use of the term. It simply means a general direction that something is moving. Most technical analysts believe that trends exist within trends. There are long-term trends, and within those long-term trends are nested medium-term trends. A particular stock may be moving up in price this year, but it will have some difficulties along the way.
Within these longer trends exist short-term trends. How we define a “term” can be problematic. There is no set period. Think of these periods of looking at a stock’s chart with a camera. When we zoom out and take a wide view of the chart, we are looking at the long term. We can zoom in and look at a quarter, a month, a week, a day, or even 1-minute increments. The most common cut points are to consider trends of over a year as long-term, trends longer than a quarter (3 months) as medium-term, and trends of less than a month as short-term.
Trends in asset prices can be hard to see in charts, especially when we are zoomed in and looking at the short term. There tends to be a lot of up and down movement, and the chart can look like a heart monitor. When it comes to asset prices, there is usually a movement up or down over a specific period. When there is an uptrend, the chart will show a series of higher highs and higher lows. When there is a downtrend, the chart will show a series of lower highs and lower lows.
A trend line is a simple charting technique consisting of adding a line to an asset’s price chart to represent the overall trend. Drawing a trend line can be as simple as drawing a straight line that connects lower lows or higher highs to show the general trend direction. We can also use statistical tools to see these “hidden” trends, such as regression lines or moving averages.
Either way, the chartist is trying to “cut through the noise” and see what the trend looks like. When the trend line is flat (there is no trend either up or down), investors often refer to this as a sideways movement. Such lack of movement is very frustrating to most traders since there is no way to profit when prices do not change (this is not always true). If we draw a line for both the highs and lows, we have two lines that form a price channel.
Traders (and talking heads) often speak about the ongoing battle between bulls and bears, or the struggle between buyers (demand) and sellers (supply). Technical analysts will tell you that these epic battles are fought on lines referred to as the support and resistance levels. These are the price points where the most trading occurs. Support levels are where demand is perceived to be strong enough to prevent the price from falling further.
Conversely, resistance levels are prices where supply is thought to be strong enough to prevent prices from rising higher. Part of the trend is to bounce around within the price channels, and traders will buy when a price touches support and sell when it touches resistance levels. If a price breaks above resistance, the resistance level becomes support for the next leg higher. Breaking out above resistance, then, is a bullish sign. As you would expect, falling below support is a bearish signal, and the former support level becomes the resistance level for the next leg.
Volume is the number of shares that trade over a given period, which is most often one day. On price charts, the volume is expressed as a bar chart directly below the price chart with the height of the bar showing how many shares have traded per period. Volume charts can also be evaluated to show trends of increasing or decreasing volume over time. To confirm trends and chart patterns, Technical analysts use volume. The strength of a price movement is measured chiefly by the volume. If a price changes substantially on low volume, it is not likely the change is sustainable. If the change occurs on heavy volume, then it may well signal a reversal of the price trend. A final important concept to understand is that price is preceded by volume. Technical analysts closely watch volume to predict when reversals are likely to occur. This means that volume changes can be a predictor to price changes. If the volume is decreasing in an uptrend, it could signal that the uptrend is ending and a reversal may be likely.
Identifying trends, support and resistance levels, and price patterns leaves much up to the subjective impressions of the trader. Some traders prefer methods that are more objective. Emotions and biases may cloud an investor’s judgment. In other words, there is a tendency to see what you want to see in chart patterns and “eyeballed” trend lines. Using indicators and oscillators is one way to reduce the degree of discretion required in technical analysis. Indicators like moving averages help determine the trend and provide potential entry signals. Oscillators help identify changes in momentum and sentiment.
Professor Malkiel provides us with a blistering attack of technical analysis. Perhaps the most devastating wave of this attack is when he compares the stock market to the average length of a hemline in women’s fashion and finds a correlation. In other words, technical analysis spends all of its time looking for correlations, but most of these correlations are spurious at best. By spending all of your time looking at charts, you’re essentially cutting yourself off from a broader picture, making the spurious correlations even worse.