Technical Analysis

Technical analysis- is essentially the making and interpreting of stock charts. Thus its practitioners are usually referred to as chartists. They study the movements of common stock prices and the volume of trading in past years to try to determine future changes of the stock prices. Most chartists believe that the market is 10% logical and 90% psychological. They also generally subscribe to the castle-in-the-air school and view the investment game as one of anticipating how the other players will behave. Charts tell of what trends have happened in the past and under careful study these chartists hope to be able to determine what the other players are doing to shed some light on what the crowd is likely to do in the future.

• Castle in the Air Theory
  • This theory analyzes how the crowd of investors will act in the future and the tendency in periods of optimism to build their hopes into castles in the air. Investors try to beat the gun by estimating what investment situations are most suceptible to public castle building and then buy them before the crowd.

Principles

1. All information about earnings, dividends, and future performance of a company is automatically reflected in the company's past market prices. A chart showing these prices and the volume of trading already comprises all the fundamental information, good or bad, that the security analyst can hope to know
2. Prices tend to move in trends: A stock that is rising tends to keep rising, whereas a stock at rest tends to remain at rest

Creating a Chart

• Most often a chart is created using the stock prices over a given time. A vertical line is drawn for each day that represents the high and low price of the stock. Then the vertical line is crossed with a small horizontal line to represent that day’s closing price.

• If the chartist sees an uptrend which is called a bullish signal then they are likely to buy the stock.

• Another trend they might see is called a head and shoulders formation because the stock rises and then falls slightly, forming a rounded shoulder. It rises again, going slightly higher before once again falling forming a head. Then finally rises slightly before decreasing steeply. This formation usually tells the chartist to sell at a certain price.

• Finally the chartist has to worry about what is referred to as the bear trap. This is where there is a head and shoulders formation but instead of the finally shoulder decreasing all the way it shifts and increases steeply. In this situation the chartist would not what to sell but if they did they might try to quickly buy back their stock.

Why is charting supposed to work?

1. It has been argued that the crowd instinct of mass psychology makes it so. That with the price of a speculative favorite going higher and higher more investors will try to jump on the bandwagon to try to receive a return and with each addition rise the investors expect a future rise.
2. There may be unequal access to fundamental information about a company. If some favorable news is discovered it is alleged that the insiders are the first to know and act. They buy more stock which causes the price to rise before the information is publicly known. So a chartist following carefully may be able to see the trend before the rest of the crowd and be able to make high profits.

"When I come into this office I leave the rest of the world outside to concentrate entirely on my charts. This room is exactly the same in a blizzard as on a moonlit June evening. In here I can't possibly do myself and my clients the disservice of saying 'buy' simply because the sun is out or 'sell' because it is raining."- the original chartists, John Magee

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Random Walk | Speculative Bubbles | Fundamental Analysis | Technical Analysis | Efficient-Market Hypothesis | Non-Random Walk Theory | Market Efficiency vs. Behavioral Finance