The Power of Technical Analysis

Technical analysis is the study of share prices. By researching the past performance of a share, we can gain an insight into how it will likely perform in the future.

To fully appreciate the power of technical analysis it is important to understand the basics. There are three key principles upon which technical analysis is based:

• Everything is discounted and reflected in market prices.
• Prices move in trends and trends persist.
• Market action is repetitive.

Let’s examine each principle in detail.

The first and most important principle is that everything is discounted and reflected in market prices. All knowledge, regardless of type (fundamental, political, economical, psychological or other) is already reflected in market prices.

It can be time consuming studying fundamental information such as company financial statements, earnings and P/E ratios in an attempt to determine the potential for a share to rise in value. The real value of a share at any point in time is determined solely by supply and demand, as reflected in trades made at the stock exchange.

Technical analysts do not care what the underlying forces of a shift in supply and demand are; instead he or she is interested in what occurs to the price.

If demand is greater than supply, prices will increase. On the other hand, if supply is greater than demand, prices will decline.

The study of market prices is all that is necessary to make money from the stock market.

The second principle on which technical analysis is based is that prices move in trends and trends persist.

The supply and demand balance sets a trend in motion. Once in motion, a trend remains intact until it ends. For example, if a stock’s price is moving up, it will continue its rise until there is a clear change in direction.

It is far easier to follow the trends, rather than fight them. The old Wall Street adage, “the trend is your friend” is true because, once begun, a trend is likely to continue once it is in place. A trend will usually give us warning that it is about to change direction. The warning can sometimes last a day or longer, so it is important to become familiar with recognising the signs.

The final key principle on which technical analysis is based is that market action is repetitive. Certain patterns appear time after time on charts. These patterns have meanings that can be interpreted in terms of probable future price movement.
Although not infallible, the odds are in the analysts’ favour. Common reversal patterns include Double Tops, Shooting Stars, Doji’s and Head and Shoulders.

These patterns, when seen during an uptrend (bull run) consistently identify a likely trend reversal, i.e. a fall in share prices.

Human nature is such that it tends to react to similar situations in consistent ways. As a rule, people will act the same in the future as they have in the past.

Since the stock market is a reflection of the actions of people, technical analysts study it to determine how people will react under certain conditions and thus, how share prices will move. Technical analysts analyse the recurrence of similar characteristics in an attempt to identify the likely future price direction.

As you can see, technical analysis can be defined as the study of individual share prices and the overall market based on supply and demand. Technical analysts record, usually in chart form on a computer, historical and up-to-date price and volume activity and deduce from that pictured history the probable future trend of prices.

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