Should I buy today? What will prices be tomorrow, next week,
or next year? Wouldn't investing be easy if we knew the answers
to these seemingly simple questions? Alas, if you are reading
this website in the hope that technical analysis has the
answers to these questions, I'm afraid I have to disappoint you
early--it doesn't. However, if you are reading this note with
the hope that technical analysis will improve your investing, I
have good news--it will!
Some History on Technical Analysis
The term "technical analysis" is a complicated sounding name
for a very basic approach to investing. Simply put, technical
analysis is the study of prices, with charts being the primary
The roots of modern-day technical analysis stem from the Dow
Theory, developed around 1900 by Charles Dow. Stemming either
directly or indirectly from the Dow Theory, these roots include
such principles as the trending nature of prices, prices
discounting all known information, confirmation and divergence,
volume mirroring changes in price, and support/resistance. And
of course, the widely followed Dow Jones Industrial Average is
a direct offspring of the Dow Theory.
Charles Dow's contribution to modern-day technical analysis
cannot be understated. His focus on the basics of security
price movement gave rise to a completely new method of
analyzing the markets.
You can check the technical's section on our website for
some basic technical indicators of all listed stocks
The Human Element
The price of a security represents a consensus. It is the
price at which one person agrees to buy and another agrees to
sell. The price at which an investor is willing to buy or sell
depends primarily on his expectations. If he expects the
security's price to rise, he will buy it; if the investor
expects the price to fall, he will sell it. These simple
statements are the cause of a major challenge in forecasting
security prices, because they refer to human expectations. As
we all know firsthand, humans are not easily quantifiable nor
predictable. This fact alone will keep any mechanical trading
system from working consistently.
Because humans are involved, I am sure that much of the
world's investment decisions are based on irrelevant criteria.
Our relationships with our family, our neighbors, our employer,
the traffic, our income, and our previous success and failures,
all influence our confidence, expectations, and decisions.
Security prices are determined by money managers and home
managers, students and strikers, doctors and dog catchers,
lawyers and landscapers, and the wealthy and the wanting. This
breadth of market participants guarantees an element of
unpredictability and excitement.
If we were all totally logical and could separate our
emotions from our investment decisions, then, fundamental
analysis the determination of price based on future earnings,
would work magnificently. And since we would all have the same
completely logical expectations, prices would only change when
quarterly reports or relevant news was released. Investors
would seek "overlooked" fundamental data in an effort to find
The hotly debated "efficient market theory" states that
security prices represent everything that is known about the
security at a given moment. This theory concludes that it is
impossible to forecast prices, since prices already reflect
everything that is currently known about the security.
The future can be found in the past
If prices are based on investor expectations, then knowing
what a security should sell for (i.e., fundamental analysis)
becomes less important than knowing what other investors expect
it to sell for. That's not to say that knowing what a security
should sell for isn't important--it is. But there is usually a
fairly strong consensus of a stock's future earnings that the
average investor cannot disprove.
"I believe the future is only the past again, entered
through another gate." - Sir Arthur Wing Pinero, 1893
Technical analysis is the process of analyzing a security's
historical prices in an effort to determine probable future
prices. This is done by comparing current price action (i.e.,
current expectations) with comparable historical price action
to predict a reasonable outcome. The devout technician might
define this process as the fact that history repeats itself
while others would suffice to say that we should learn from the
The Roulette Wheel
In my experience, only a minority of technicians can
consistently and accurately determine future prices. However,
even if you are unable to accurately forecast prices, technical
analysis can be used to consistently reduce your risks and
improve your profits.
The best analogy I can find on how technical analysis can
improve your investing is a roulette wheel. I use this analogy
with reservation, as gamblers have very little control when
compared to investors (although considering the actions of many
investors, gambling may be a very appropriate analogy).
"There are two times in a man's life when he should not
speculate: when he can't afford it, and when he can." - Mark
A casino makes money on a roulette wheel, not by knowing
what number will come up next, but by slightly improving their
odds with the addition of a "0" and "00."
Similarly, when an investor purchases a security, he doesn't
know that its price will rise. But if he buys a stock when it
is in a rising trend, after a minor sell off, and when interest
rates are falling, he will have improved his odds of making a
profit. That's not gambling--it's intelligence. Yet many
investors buy securities without attempting to control the
Contrary to popular belief, you do not need to know what a
security's price will be in the future to make money. Your goal
should simply be to improve the odds of making profitable
trades. Even if your analysis is as simple as determining the
long-, intermediate-, and short-term trends of the security,
you will have gained an edge that you would not have without
Consider the chart of Merck in Figure 1 where the trend is
obviously down and there is no sign of a reversal. While the
company may have great earnings prospects and fundamentals, it
just doesn't make sense to buy the security until there is some
technical evidence in the price that this trend is
If we accept the fact that human emotions and expectations
play a role in security pricing, we should also admit that our
emotions play a role in our decision making. Many investors try
to remove their emotions from their investing by using
computers to make decisions for them. The concept of a "HAL,"
the intelligent computer in the movie 2001, is appealing.
Mechanical trading systems can help us remove our emotions
from our decisions. Computer testing is also useful to
determine what has happened historically under various
conditions and to help us optimize our trading techniques. Yet
since we are analyzing a less than logical subject (human
emotions and expectations), we must be careful that our
mechanical systems don't mislead us into thinking that we are
analyzing a logical entity.
That is not to say that computers aren't wonderful technical
analysis tools--they are indispensable. In my totally biased
opinion, technical analysis software has done more to level the
playing field for the average investor than any other
non-regulatory event. But as a provider of technical analysis
tools, I caution you not to let the software lull you into
believing markets are as logical and predictable as the
computer you use to analyze them.