Underlying Assumptions of Technical Analysis
Technical analysis is the practice of valuing stocks on past volume and pricing information. Technical analysis assumes the following:
- Market value of the asset is a reflection of supply and demand of the asset.
- Supply and demand are driven by rational factors, such as data and economic analysis, as well as irrational factors, such as guesses.
- Markets and individual stocks move together given trends.
- Shifts in supply and demand will shift the trends in the market and can be detected in the market.
If the concept of technical analysis is new to you, be sure to review our Technical Analysis tutorial.
Technical vs. Fundamental Analysis
The main difference between technical analysis and fundamental analysis is the use of financial statements to value equities. Technical analysis is the practice of valuing stocks on past volume and pricing information. Technical analysis combines both the use of past information (how stocks have reacted previously) and "feeling" (how the market is moving the name) to value a security.
Fundamental analysis, however, takes a more formal approach. Fundamental analysts review the financial statements of a company and generate metrics, such as price-to-book value and enterprise value-to-EBITDA to value a security.
Advantages of Technical Analysis:
- Technical analysis is easy to understand and can be performed relatively quickly, especially with the aid of one of the many types of charting software.
- Technical analysis does not rely on the use of financial statements for valuation purposes.
- Rather than strict fundamental valuation, technical analysis takes into account the "feeling" of the market, which is subjective.
Challenges to Technical Analysis:
- The past is not always an indication of future results, calling into question the validity of technical analysis.
- Technical analysis violates the premise of EMH because EMH believers assume that price adjustments happen too quickly to be profitable.
Challenges to Technical Analysis Trading Rules
- Technical analysis is subjective and cannot be used to make consistent decisions.
- Signals that indicate action in technical analysis may change over time.
Technical indicators are categorized into the following:
1. Contrary Opinion
Traders that follow this type of analysis view the majority as being incorrect and choose the opposite direction. There are many indicators that can be followed:
- Mutual fund cash positions - given a mutual funds holds a part of its assets as cash, traders monitor cash positions of mutual funds (reported monthly) and trade against them accordingly. To a trader, a large cash position in a mutual fund would be an indication to buy (mutual funds are bearish, hence trader would be bullish).
- Investment advisory opinions - To a trader, a large number of bearish investment advisory opinions would indicate it was time to buy, again taking the contrary view.
- CBOE Put/Call Ratio - given a large put-to-call ratio would indicate that the market maintains a bearish view, the contrarian trader would take the opposite view and see it as a bullish indicator.
2. Smart Money
Some investors are deemed smarter than others and, therefore, their money is considered "smart money". Traders typically follow the smart money. The following are viewed as smart-money indicators.
- Confidence Index - This index is the average yield of the top 10 corporate bonds divided by the Dow Jones average yield of 40 bonds. A bullish indicator is when the yield spread narrows, indicating investors are willing to invest in risky bonds.
- Margin Debt - an increase in margin would indicate that investors are becoming more bullish.
3. General Market
- Breadth of market - this is the measure of stock declines versus stock increases for the day, indicating direction (a technical indication for the market).
- Short interest - this is the measure of stocks sold short. If short interest increases, that is a bullish signal as investors will have to buy the stock to cover the shorts.
4. Stock Price and Volume Techniques
- Dow Theory - A theory which says the market is in an upward trend if one of its averages (industrial or transportation) advances above a previous important high, it is accompanied or followed by a similar advance in the other. The theory also says that when both averages dip below previous important lows, it's regarded as an indicator of a downward trend.
- Support and Resistance - this is the view, given the psychological nature of investors, that a stock does not often trade above its support and resistance level. Traders monitor the levels for strategy. If a stock breaks out of its resistance level, it moves to the next resistance level. Learn more about these key technical indicators that not only display strength and weakness but also act as buy and sell indicators in the following article: Support & Resistance Basics
- Moving-average - this measures the average moves of a stock over a specified time period. This measure removes daily fluctuations in a price change and the trend can be more readily discerned. Take a closer look at the linearly weighted moving average and the exponentially smoothed moving average within the following article: Basics of Weighted Moving Averages
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