Technical analysis is a study of charts to forecast the future direction of prices. Technical analysts study past market data, primarily price and volume..
Technical analysts are often called chartists because historical prices downloaded into a variety of charts are the primary sources of information for the technician. Most technical analysts don’t know, or care, about a company’s underlying business model. They just care about its price history, its volume and whether their indicators are telling them to buy or sell. In this way, the technician is saved from a company’s hype and its ability to baffle company analysts.
Since fundamental analysis – which analyses such things as a company’s financial statements, industry growth rates and its competitors - is based on publicly available information, the technical analyst argues that knowing the fundamentals of a company hardly offers one investor an advantage over others. In other words, since a company’s fundamentals is common knowledge (and therefore applied by investors to buy and sell the stock), the technician assumes that such information is already factored into a stock’s price. So rather than stressing over calculating the return on equity (ROE) of a stock, or coming up with the price/earnings ratio as a guide to valuation, the technician simply looks to the share price. According to the technical analyst, price changes over the short term hinge on the psychology of the market or forces of supply and demand. And all of this information is summed up in the chart.
Technical analysts believe that investors are fairly predictable. They regularly follow patterns of behaviour such as succumbing to emotions of greed and fear. If a company announces headline-grabbing news, for instance, investors gobble up its shares because other people are doing the same.
A November 2006 study by Brad M Barber and Terrance Odean at the University of California noted this tendency of investors to act in patterns, such as gravitating towards attention-grabbing stocks, including companies in the news, stocks experiencing abnormally high trading volume and stocks with extreme one-day returns. Since there are so many stocks to choose from investors limit their choices to companies that have recently caught their attention. (The study concluded that this behaviour does not generate superior returns, in fact, quite the opposite).
This tendency of investors to react to market stimuli in similar ways creates patterns of price behaviour. The technician aims to use this behaviour to chart the timing of their entry and exit into a stock.
As an example, let’s say that a large super fund started buying an enormous tranche of shares in a given stock over a period of a week. The aim of the technician is to spot activity that can lead to extreme price movements. The heightened volume and buying pressure of the super fund picking off orders should alert the technician to the activity. A clever technician would jump on for the ride.
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