Technical Analysis (TA)

Technical analysis is the  use of price and volume data to value stocks. It upholds the idea that supply and demand collectively constitute market forces – ultimately determining 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 interact without any inhibition. In such a market, traders are not  subjected to government impediments or some other form of constraint. Proponents of technical analysis argue that supply and demand determine stockprices in real-time.

Principles of Technical Analysis

Principles of Technical analysis are:

1. The market discounts everything: It is considered that a financial instrument’s price reflects all of the factors that influence it.
2. Price moves in trends and countertrends: Prices follow trends, and if a trend is identified, future price movement will be in line with it.
3. Price action creates patterns that tend to recur and may, therefore, be cyclical. Market psychology is the reason price movements repeat themselves. Price changes can then be charted, thereby allowing technicians to spot patterns.

Assumptions of Technical Analysis

The following are the assumptions of Technical Analysis:

1. All fundamental factors are priced into the stock price.
2. Price movements follow particular trends (i.e. upward, downward, sideways, or a combination of these directions).
3. The patterns and trends are repetitive and stem from market psychology. This  implies that the repetitive nature of price movements makes it possible to predict future price movements. 

Technical analysis deviates from the efficient market hypothesis, which claims humans always exercise rationality in decision-making and buying and selling financial assets. Technicians heavily link TA to the study of investor psychology and human behavior in different circumstances. Technicians believe that  evidence gathered over the years that shows that investors often respond  in the same manner 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

1. Pricing of assets that do not have future cash flows (dividends or other forms of income).
2. Analysts can use the method to estimate fair values of assets in situations where financial statements are fraudulent, effectively ruling out the reliability of the fundamental analysis.

The analysis of trading volumes and price fluctuations is done graphically and displayed in the form of charts. For this reason, technical analysis is widely considered easier to conduct and interpret  compared to fundamental analysis.

IIt is imperative to note that  using past data and trends to predict  a market’s future may not always be valid. We cannot rely on the past as an accurate indicator of future results.

Question

Which of the following is least likely an assumption inherent in technical analysis?

1. Patterns and trends are non-repetitive.
2. Supply and demand determine the value of assets.
3. Rational and irrational forces drive supply and demand.

Solution

The correct answer is A.

According to technical analysis, patterns and trends are repetitive.

Other assumptions inherent in technical analysis are:

• All fundamental factors are priced into the stock price.
• Price movements follow particular trends (i.e. upward, downward, sideways, or a combination of these directions).
• The patterns and trends are repetitive and stem from market psychology. This  implies that the repetitive nature of price movements makes it possible to predict future price movements.