Technical analysis is a specialty within the financial market that involves predicting future financial trends by capitalizing on certain key characteristics of trading activity. The term “technical analysis” was first used in the mid-1920s by Charles Dow who discussed it as a method to explain stock price movements based on secondary indicators.
It works as follows: Analysts observe the behavior of various market participants and identify patterns in their trading activities. They then use these observations to develop trading strategies, often with mathematical formulas, which predict future price movements based on price changes observed from past data. From there, traders are able to take advantage of an anticipated change in market value or perform risk management using a particular strategy that they believe will yield positive results. As a result, technical analysis has become widely accepted by traders and investors as a way to predict future movements in financial markets.
As an example, the simplest type of technical analysis is trend trading; this technique involves identifying trends or patterns in price movements and exploiting these trends by trading on them. In trend trading, traders constantly monitor the market’s price action to determine if there are any obvious trends present. If so, they will capitalize on these movements by trading for profit.
Technical analysis is based on the theory that historical stock price movements reveal useful information about future price behavior. This point of view relies heavily on the capital asset pricing model (CAPM), which is a formula that was developed by Sharpe in 1964 to compare trading results with market expectations. It calculates the amount of excess return for an investment relative to the amount of risk taken to achieve that return. The CAPM also helps measure the reward-to-risk ratio for an investment, which can be used to determine if a security is fairly priced or overpriced compared to its peers. Technical analysis relies on this ratio to determine if a security is undervalued or overvalued compared to its peers.
Technical analysts use several statistical tools to identify market trends, which include:
The study of price patterns and relationships is known as technical analysis. Technical analysis begins with observing stock prices and charting the price action over a period of time. It then uses various indicators, such as moving averages and volume to identify trends in trends. In the final step, technical analysts attempt to predict future price movements through mathematical formulas based on past price movements. This includes using Fibonacci retracements, Elliott waves, support-and-resistance levels and other forms known as technical indicators.
Technical analysis is a multi-disciplinary field that includes studies in mathematics, science, finance and psychology. In the 1980s, researchers from the University of Chicago and University of Toronto began studying technical analysis from a behavioral finance point of view. In addition to studying price patterns, they were able to develop an indicator known as Market Volatility Index (MVI) which helps technical analysts predict market volatility. Researchers in this field, such as Laurice Adelman and Stephen Beckwith both from Bentley College in Waltham, MA have tested numerous technical indicators through various statistical methods; many findings back up the theory that certain technical indicators such as RSI (Relative Strength Index) are more useful than others over time.
The concept of technical analysis has been around since the first stock markets existed; however it was an informal process. This differs from technical analysis as presented today because it was not founded on a set of rules governing the way stocks move, but instead on experience, meaning that the skills needed to succeed were highly dependent on the individual’s own perception of patterns. Technical analysts could be found in stock exchanges throughout history.
In 1714, Dutch financial journalist Johannes de Witt published De Conjunctuur (“The Conjuncture”), a treatise on economics and technical analysis. The first known chart is the “Sellier-Bachelier Chart” from 1853, and it was published by French mathematician Edmond Fischer who began applying statistical methods to analyze price-change data. Fischer is credited with being the first person to demonstrate that support and resistance levels were an integral part of technical analysis. Subsequently, in 1901 and then in 1903, Charles Dow published charts based on a ticker tape system he set up that would record the price changes of twelve stocks on a ticker tape, which was used to make a new chart every day.
Dow’s charts included stock price movements from September 30, 1900 onward. In February, Dow published his first edition of the “Wall Street Journal”, which was a 16-page weekly that covered financial news and featured a 12-month stock market index. Dow’s chart showed a bull market starting at the turn of the century, and it was called the “Dow Theory”. The main premise of Dow’s theory was price increases followed by price falls in equal numbers, and vice versa. This became known as the “Golden Cross” method and is a precursor to Elliott Wave analysis.
In 1912, Charles Dow’s eldest son Edwin Dows graduated from Yale University’s Sheffield Scientific School with a degree in chemistry. He then went on to work for the New York Life Insurance Company before starting his own research laboratory in 1929. In 1944, he published “Technical Analysis of Stock Trends”, which became known as the “Dow Theory” of technical analysis. The book was published when many other technical analysts were no longer following Dow’s original trading theory.
Edwin Dows recognized that stock prices fluctuate and move in cycles, which can be divided into five distinct stages of movement:The Dow Theory is mainly based upon moving averages, support and resistance levels, and volatility. It is based on the premise that there is an orderly pattern in the market, in which important events cause a change in trend. A bullish move occurs after an important event, such as an earnings report or a quarterly financial report. This causes investors to raise their demand in anticipation of future price increases to follow.
Based on these concepts, Dows proposed three rules that were used to determine when a bull market was starting:Dows went on to develop other forms of technical analysis including the “Thornthwaite” curve and Fibonacci ratios. Prior to this, most technical traders relied on the “Golden Cross” method. Edwin Dows also published a second book titled “Technical Trading Systems” in 1943, which described the use of “Fibonacci ratios, time and moving averages in forecasting market trends”.
In 1934, Garvin Thomas created a charting system that was based on Fibonacci’s series. This charting technique of his was based on how prices coalesced to form a figure eight pattern, and he studied the behavior of the movements of certain stocks. As part of his work he developed an indicator called the “Vega” which uses arithmetic progression and Fibonacci ratios. Vega was considered as one of the first Elliott wave indicators, and it consisted of two moving averages, a shorter-term one and a longer-term one. Thomas published his work on the techniques and benefits of Elliot Wave theory in 1939.
The idea of using Fibonacci ratios to predict price movements was later popularized by Charles Dow’s son Edwin Dows in his book “Technical Analysis for Stock Speculation” (1944). He claimed that the two numbers found in the sequence (1, 1, 3, 5, 8…) were consistent with natural phenomena such as pineapples appearing in sets of threes and fives. The ratios present mathematical patterns that are useful for predicting economic cycles.