Technical Analysis

Technical analysis is the forecasting of market prices by means of analysis of data generated by the process of trading.

Some technical analyze say they don’t actually “forecast” market prices with their technical analysis methods. However, I suggest for a buy or sell signal to be useful, it must necessarily have predictive ability. That is, if you buy because your technical indicator defines a price trend as “up”, then you necessarily believe the price trend will continue to go up: it has predictive ability. Otherwise, there would be no use in applying the signal. The reason for applying the signal is you believe it has predictive ability: it can signal a rising or falling price trend.

Technical analysis is based on the belief that markets discount everything except information generated by market action itself, therefore, all you need is data generated by market action. In some technical analysis literature, this seems to be in direct conflict with the Efficient Markets Hypothesis (EMH). Efficient Markets Hypothesis is the theory that markets discounts and prices in information, so there is little to know possibility to find mis-priced securities. EMH also theorizes that price trends do not exist- prices are random. This seems in conflict because technical analysis and quantitative analysis studies show that the market punishes and rewards certain factors. Behavioral Finance studies show that markets under-react and over-react to information – it’s not so efficient. Because of under reaction and over-reaction, prices drift in one direction or another over time, or prices overreact and move too far directionally.

The Introduction to Technical Analysis by Martin Sewell is a good start to learn more about technical analysis.

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