WHAT IS TECHNICAL ANALYSIS ?
Technical Analysis is study of market action, primarily through use of charts, for the purpose of forecasting future price trends. Market action includes three principal source of information - price, volume and open interest. Technical analysis is based on the premises that market action discounts everything, prices moves in trends and history repeats itself. Technical analysis can be applied across all time frames, from minutes to decades.
Market action discounts everything - Technician believes that anything that can possibly effect price be it fundamentally, politically, psychological or otherwise is actually discounted and already discounted in the price by the market. As a rule chartist is not concern with the reason why the prices rise or fall as often the other economical factors are contradicting current market action. Technical analyst believes that stock markets are lead indicators to economy.
Prices move in trends - Trend in motion is more likely to continue that to reverse. Uptrend is a situation in which each successive rally closes higher than the previous rally high and each successive rally low also closes higher than the previous rally low. In other words uptrend has higher tops and higher bottoms. Opposite situation of lower tops and lower bottoms defines a downtrend.Major Trends have three Phases - Accumulation, Participation & Distribution are the key phases in major trends. In the accumulation phase the informed insiders know that in the current downtrend, markets have fully discounted the bad news, they accumulate at discounted prices. Public participation phase starts when prices are rising rapidly and now even the business & economic news is improving. Distribution phase starts when all the media carries bullish headlines, there is speculative buying on huge volumes. During this last phase the same informed investor who began accumulating near the bear market bottom, begins to distribute before anyone else starts selling.
History repeats itself - All through time, people have basically acted and reacted the same way in the market as a result of: greed, fear, ignorance, and hope. That is why the numerical formations and patterns recur on a constant basis. Much of the study of the market has to do with the study of human psychology. Chart pattern which have been identifies and categorized over past hundred years, reflect certain pictures that appear on price charts. These picture reveal the bullish or bearish mood of the market. Since this patterns have worked well in the past, it is assumed that they will continue to work in future.
CRITICISM OF TECHNICAL APPROACH
Self Fulfilling Prophecy - Critics say that "use of chart patterns have been widely & known for several years. Many traders are familiar with the same and act on them in concert". Truth is charts reading is an art. Chart patterns are seldom so clear that there would be consensus. Even if all participants agreed on market forecast they would not necessarily enter the market in same time or in the same way.
"Can past be used to predict future?" - Critics of technical approach bring up this point. But every other method of forecasting from weather to fundamental analysis is based completely on the study of past data. Chart analysis is just another form of time series analysis, so it seems that the use of past data to predict the future is grounded in sound statistical concepts.
Random Walk Theory - It states that price changes are random and serially independent, so price history is not reliable indicator of future price direction. Theory is based on efficient market hypothesis, which holds that prices fluctuate randomly bout their intrinsic value. It holds that best market strategy is to follow simple buy and hold strategy. There is little randomness or noise in all markets. But the ability of market to quickly discount all information into the prices is the basic premise of technical analysis. You just need to study price and its patterns to profit from the moves, rather than looking after the factors for the changes in the price.