Technical analysis is neither warm nor fuzzy, but its roots are in human emotion. Specifically: greed and fear.
Technical trading is neither new nor stylish.
Technical analysis had been in use for more than 100 years in Asia and Europe before that historic event on May 17, 1792, when 24 brokers gathered beneath a buttonwood tree on the avenue Dutch settlers in the New World called "de Waal Straat" and inked the agreement that created what would become the New York Stock Exchange.
Despite its long history, technical analysis doesn’t always get the respect it may deserve. Financial pundits regularly dismiss it as a type of “voodoo,” and most investors are better versed in the more widely accepted school of fundamental analysis. However, understanding the underlying mechanics of technical analysis can add another powerful weapon to your trading arsenal.
Simply put, technical analysis is a graphic representation of buying and selling action among market participants. By plotting just two data points—price and volume—technical charts and indicators paint a picture of what’s happening with a particular stock or index. Technical analysts track the patterns to forecast movement and try to capture profits.
Technical traders believe that all buying and selling decisions are based on human emotions, specifically greed and fear. When investors are pessimistic or worried about a stock’s performance, fear of losing money may trigger them to sell. But when investors are bullish on a stock, greed drives them to buy.
These universal and consistent emotions create patterns in price and volume that repeat over time. Some patterns bear exotic names like “ascending triangle,” “bull flag,” or “rising wedge,” but they are all based on basic, accepted theories of supply and demand. The technical trader identifies these patterns and attempts to take advantage of them.
The beauty of technical analysis is that it takes subjectivity out of the decision-making process. Technical traders use specific criteria to determine their entries and exits.
Let’s consider the moving average, one of the most popular technical studies. If your trading plan is to stay long on a stock that closes above a specific moving average and sell if it closes below, that leaves no room for interpretation. And that’s the point. Technical traders don’t worry about subjective matters like revenue, earnings, dividends, or product cycles. Instead, they concentrate on charts, studies, or indicators, all derived from the objective criteria of price and volume. They try to make buying and selling decisions as automatic as possible.
Despite the cold and calculating nature of technical analysis, it’s more malleable than you might expect. There are numerous ways to calculate a moving average, trendlines can be drawn in a variety of styles, and even the formulas for technical indicators can be “adjusted.”
Technical traders use charts that reflect others’ emotions in order to take their own emotions out of the picture. But the traders who do best with technical analysis are those who can add a touch of art to all that science.
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While this discusses technical analysis, other approaches, including fundamental analysis, may assert very different views.
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