Technical analysis is the practice of using price and volume data to value stocks. It upholds the idea that supply and demand – that collectively constitute market forces – ultimately determine the stock price. Technical analysis is a concept widely used to value securities in free markets around the globe.
Breaking Down Technical Analysis
A free market is one where willing buyers and willing sellers can freely interact without being subjected to government impediments or some other form of constraint. Proponents of technical analysis argue that supply and demand determine stocks prices in real time.
The following are the main assumptions inherent in technical analysis:
- Market forces (supply and demand) determine the market value of assets.
- Rational factors – as well as irrational ones – collectively drive supply and demand e.g. data and guesswork respectively.
- Individual stock prices change to reflect periodic trends exhibited by the market as a whole.
- Patterns and trends are repetitive. Therefore, we can actually predict future price movements.
- Emotions play a major role in determining human behavior, which can be quite erratic.
Technical analysis deviates from the efficient market hypothesis which claims humans always exercise rationality in decision making, and in extension, buying and selling of financial assets. In fact, technicians heavily link TA to the study of investor psychology and human behavior in different circumstances. Technicians believe there is convincing evidence gathered over the years that shows investors often respond similarly when subjected to similar circumstances.
The Line between Technical and Fundamental Analysis
While technical analysis values assets based on trading volume and pricing data, fundamental analysis is more conservative. Fundamental analysis values assets based on the information recorded in financial statements. To value a security, fundamental analysis looks into metrics such as the price-to-book value and company earnings before tax.
Applications of Technical Analysis
- Pricing of those assets without future cash flows (dividends or other forms of income)
- Analysts can use the method to estimate fair values of assets in situations where financial statements are fraudulent, effectively ruling out the reliability of fundamental analysis.
The analysis of trading volumes and price fluctuations is done graphically and displayed in form of charts. For this reason, technical analysis is widely considered easier to understand and conduct compared to fundamental analysis.
However, using past data and trends to predict the future of the market as a whole may not always be valid. We cannot rely on the past as an accurate indicator of future results.
Reading 56 LOS 56a:
Explain principles of technical analysis, its applications and its underlying assumptions.