Technical Analysis: A Primer

When you study past market data to predict future changes in the market it is referred to as technical analysis. It falls under the category of security analysis alongside fundamental analysis. In this article, we are going to discuss how technical analysis is utilized in day trading.

Fundamental analysis can be applied to micro and macro economic levels, which often differs from technical analysis. Microeconomic fundamental analysis includes studying revenues, cost, earnings, assets and liabilities, capital structure, and “soft” elements such as the quality of the management team and competitive position in the market. 

Macroeconomic fundamental analysis encompasses studying or forecasting economic growth, inflation, credit cycles, interest rate trends, capital flows between countries, labor and resource utilization and their cyclicality, demographic trends, central bank in relation to political policies and behavior, geopolitical issues, consumer and business trends, and “soft” data such as sentiment or confidence surveys.

Depending on the preference from each trader when making informed trading and investing decisions. Some traders might be more inclined to utilize one or the other and some may prefer using both.

The majority of large banks and brokerages have specialized teams in both fundamental and technical analysis. Ultimately, both forms of analysis are beneficial and effective when perfected and provide quality information to traders. When considering the different types of analysis, the more knowledge the better. The more quality information traders obtain to improve the odds of being right, the better their results will likely be in the end.

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Assumptions in Technical Analysis

Most traders tend to favor one type of analysis over the other, typically, or at least favor one type more heavily in making trading decision, but some traders and investors use both fundamental analysis and technical analysis equally.

The methodology that technical analysts rely on fall under two main beliefs. The first belief is that price histories tend to be more cyclical and the second belief is that prices, volume, and volatility of the market tend to have distinct trends.

Let’s take a look at each one more thoroughly:

Market Cyclicality

Just as human nature shows commonly shared behavioral characteristics, market history also tends to repeat itself. Specific patterns of behaviors and sequences of events rarely repeat itself perfectly, they generally tend to be comparable. This also stands true for both long-term and short-term price behaviors.

Long-term behaviors in business cycles are inherently prone to repeating themselves, such as credit booms where debt escalates to an unmanageable level for a period of time and then eventually results in financial distress due to not enough cash being accessible to service these debts. When this happens, there tends to be slow progressive gains in the stock market and other “risk-on” trades (e.g., carry trending) during the upswing and a sharp decline when a recession strikes.

Technicians operate solely on the belief that market participants are likely to repeat the behavior of the past, due to the market’s collective and patterned nature. If this were true and behaviors were always more likely to repeat themselves, that would also imply that patterns could be recognized by looking at previous data regarding price and volume in the market and use this information to predict similar reoccurrences in the future. If traders were able to identify when and where a pattern or behavior is likely to be repeated, they would also be able to identify when different risk and/or rewards of trades were going to be in their favor.

Because this is true, there is also an ongoing assumption that a market’s price should discount all information that influences a particular market. If all of this information is subsequently reflected in asset prices immediately upon release, it would be just like fundamental events, such as news and economic data, and how they currently impact the financial market. Technical analysis would then switch it’s attention to identifying trends in the market prices and evaluate how market participants value specific information.

For example, if US CPI inflation data came in a tenth of a percent higher than what was being priced into the market originally, prior to any news releases, traders would be able to determine how vulnerable the market is to that information by monitoring asset prices and any trends that exist regarding how they react immediately following this event.

If US stock futures move down X%, the US dollar index increases Y%, and the 10-year US Treasury yield increase Z%, we can generally assume the economic inputs impact specific markets. If traders could predict how sensitive the market is at different times, that information would be invaluable to use for stress testing purposes in the form of risk management. For example, if inflations were on the rise unexpectedly and increase above 1%, data points could be used regarding unexpected inflation readings in order to determine how this might affect the portfolio.

Price, Volume, and Volatility Run in Distinct Trends

Another technical analysis assumption is that market price does not move around randomly without foreseeable or logical patterns. Generally, this is a belief amongst all securities in a broader sense as well. This assumption means that it is the general belief of technical analysis that there market prices move on a continuum where there are trends that are both explainable and predictable.

With his belief in mind, consider the graph below of EUR/USD amounts from 2013-2017. When looking at support and resistance within the contest of trends, we can see how technical analysis played a role. When the euro began depreciating compared to the US dollar as a result of a divergence in monetary policy in mid-2014, technical analysts might have taken short trades on a pullback to resistance levels within the downtrend, which is marked in the image below with arrows. Once this trend faded and consolidation was occurring in the market, a technician may have chosen to start taking longs at support to play the range, while simultaneously closi