What is Technical Analysis?
The hypothesis of technical analysis
1.Market Action Discount Everything
The price of an asset is determined by the supply and demand of the market participants. This implies that any factors like economic, politic and social issues are already reflected in the price. Plus, technical analysis also believes that the psychology of the market participants is also reflected within the market. The trend may go up or down and it is believed that there is a certain reason why it is moving in that direction. But, traders don’t necessarily have to know everything but analyse the price movement.
2. Price Moves in Trend
The trend is a very important thing in terms of technical analysis. The first law of Newton, also known as Law of Inertia, implies that when an object moves to a direction, it would not stop until there is another force stopping it. This theory also applies to the market and there are tonnes of research and papers upon the trend.
3. History Repeats itself
The price movement of financial instruments is reflected on a chart. These charts are formed in 2 dimensions, consist of X-axis and Y-axis. The price movement is eventually generated by the market participants like banks, hedgefund and retail investors. Technical analysts scrutinise the patterns of the market and have realised that it is directly related to the psychology of the human being.
A famous writer Mark Twain once said: “History does not repeat but follows a certain rhythm”. Traders and investors study the past price movement and attempt to reflect on the future. This tendency would continue and will again, reflected the market.
Many people do not like to change their thoughts. Thus, instead of adopting new ideas, humans tend to stick to the original thoughts. This is the reason why the patterns in the past may tend to appear in the near future.
The Criticism of technical analysis
1.Self-Fulfilling Prophecy
This is a criticism claiming that the patterns on the chart are artificially generated by the market participants using well-known patterns. Technical analysis can be very subjective depending on the market circumstances. And critics think that the technical traders are trying to justify their prophecy.
In fact, it is very difficult to know which kind of chart pattern is forming when we are doing live trading. Even verified traders have a different perspective and advocates on the same patterns. Thus, many technical analysts tend to know the full pattern after the pattern is completed.
Nowadays, a lot of market participant uses trading system via technical indicators or strategies. There are blames saying that these systems are influencing the market and change the direction as it is intended to. On the other hand, the strategies can be millions and considering the variables, it is near to infinite. So the systems may give an impact to the market but it tends to be a temporary phenomenon.
2. Predicting the future using past data
The critics of technical analysis often say that technical analysis can not predict the future using past data or patterns and it is full of justification while making up the patterns. This is very reasonable suspicion.
But, the technical analysts would say we are not trying to predict the future but believe that there is a high probability that it would repeat a certain pattern. And these patterns are the reflection of supply & demand and psychology of the market participants.
3. Random Walk Theory
Random Walk Theory is a theory saying that the market goes up and down randomly. So even though analysing the price movement of the market, it is useless and would not be able to beat the market. Thus, this is a hypothesis claiming that the market moves randomly base on the instrintic value.
Technical analyst disagrees with this standpoint. If the market literally moves randomly, no one could have been able to beat the market and outperform. This is because all the analysis and strategies would not work if the market is very efficient. It would look like random if you do not know what you are doing. Once you research and experience enough, you will realise that the market is not efficient and does not move randomly.
The usefulness of the technical analysis
1.Visualising price data
The price movement of any asset classes is precious data for technical traders. charts are the visualised data of price movement and the trading platforms like Metatrader4 offers live price data for the forex and CFD traders. Traders believe that the chart is the best tool to analyse the patterns of the price movement.
2.Analysing trend and volatility.
The chart shows the trend and volatility of an asset instantly. This is like a map for traders to analyze the past and current market circumstances and set up the strategies to win in the near future with high probability. It also enables to let traders recognise when to enter, exit, stop-loss and profit-taking. Thus, it would be much more convenient to manage risk.
3. Past price movement on certain events.
The chart enables traders to know the market movement base on certain events in the past (like the financial crisis in 2009). So, when similar events happen, it would give them the hints to analyse and trade successfully.
4. Flexibility and various timeframe.
Technical analysis can be applied to any sort of financial market. Although the characteristics of every asset classes tend to vary, the price is formed by the market participants. Fundamental analysis takes a huge amount of time to study and research all the materials about an asset, technical analysis has no boundary. Traders can also analyse the market in a short, mid, and long period of time and trade base on their strategy
5. It is useful even for non-TA believers.
Charts are fundamentally visualised price data. It would give a big picture upon how an asset has performed even for an investor who does passive investment like asset allocation. Although the chart is widely used by the chartist, non-chartist would also found it useful.