Bulls and bears, booms and busts; each scenario provides an opportunity for profit. While long-term investors concern themselves with fundamental market movements, those playing the short game understand the importance of a little statistical know-how. Technical analysis isn’t simple, but within its techniques resides a few simple truths that can clarify the market picture and lead you to greater profit. Here are five things you need to know:
Movements Are Not Always Random
While perhaps the most obvious truth regarding technical analysis, the potential for prediction inherent in market movements represents the most powerful aspect of the practice. Simply put, if it was impossible to predict the movement of markets, analysis of any kind would be futile. However, due to emergent patterns, harnessing the statistical rationality of moving prices not only opens the door for profit, but also presents barometers that can be used to signal when trades should occur.
The key is recognizing when the market is, effectively, random, and when it is not. These periods are referred to as “trending” and “trading”. Trading periods are indicated by a series of short-term peaks and valleys, the boundaries of which are referred to as supports and resistances. Trending periods occur when these short-term highs and lows are broken, signaling a move out of or into a position and helping to guide profit, and minimize loss.
Price Discounts All Other Information
This concept, a product of Dow Theory, sets the groundwork for technical analysis by establishing a backdrop of assumptions on which to operate. According to this rule, the current price always and forever represents the fair price. This is because the current price is set by a team of thousands of analysts and financial experts; questioning the value of this much knowledge is simply foolish.
The reason this assumption is so profound is because it frees analysts to focus on price trends instead of fundamental market movements. Since determining the degree to which myriad factors contributes to price represents an insurmountable task, technicians focus on price movements instead of their motivations. This means a relative simplification of data into statistical indicators that guide decision-making.
Volume Confirms Price
However, when determining the legitimacy of price movements, raw value and highs/lows are not the only barometers available. According to Charles H. Dow, trends are confirmed by volume, due to the fact that isolated movements backed by only a few data points bear far less legitimacy than the collective decisions of the crowd. Thus, when position movements are determined, volume should always be consulted.
“What” Overshadows “Why”
As mentioned earlier, technicians are less concerned with the factors that contribute to movement than they are with the movement itself. This suggestion may seem peculiar to those with a background in fundamental analysis, as all economic changes are based on human choice. Furthermore, utilizing mathematic analysis to quantify and predict human behavior may seem like an impossible task.
What this argument fails to understand, however, is that market movements occur in aggregate. Individual human choices and responses to situations are widely varied, and predicting the behavior of a single data point likely is an impossible task. However, the price determined by the market is the product of a multitude of forces, and these collective influences result in powerful and understandable trends. Thus, once again, traders are less concerned with the reasons behind movements, as profit is the primary goal, regardless of what motivates the change. In the end the reason that technical analysis works is that its based off understanding the motivations of market participants. Human behavior since the beginning of time has been the same. No amount of evolution has changed that yet. People are still governed my the emotions of fear and greed the need to take care of their families, to be successful etc. Knowing that we can properly predict what a stock or the market will do when faced with certain situations or certain scenarios as historically we have seen the same thing over and over. This understanding can be applied to longterm investing, IRA investing, swing trading, and daytrading as people and their patterns are always the same. That is how we get our edge.
Not Everything Works
A cursory glance at a manual on statistical analysis or a quick chat with another day trader may lead one to believe that anyone can use the technique to great effect. The problem with this thinking is that it ignores the malleability of technical analysis, the breadth of methods that can be used, and a key tenant of market behavior.
As discussed, price represents the aggregate value placed on a security by a battery of experts, traders, and analysts. The crux of this is that other traders are helping to determine the value of a security as well. If every trader needs to make money and outperform the crowd, then it is unlikely that any trader would make money using the same, agreed upon value as everyone else. Beating the market means finding your own niche and using technical analysis in innovative ways to discover under-valued positions. With plenty of options to choose from, no one option guarantees success; the potential is unlocked by skill, experience, and smarts.
Plenty of people claim to have the inside scoop on stocks, but only the judicious application of intelligent analysis can divine what’s hot and what’s not. The predictability of markets and the focus on current price will help free you from superfluous concerns, while checking volumes as a component of your own unique trading style will confirm positions and build profitability. For those wishing to build wealth, the stock market provides that opportunity, and those wishing to succeed will find just what they’re looking for through this sophisticated and analytical methodology.
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