The Handbook of Technical Analysis + Test Bank. Lim Mark Andrew

predicting future behavior.

      The following definition of technical analysis tells us that it is the study of pure market action and not the fundamentals of the instrument itself.

      It refers to the study of the action of the market itself as opposed to the study of the goods in which the market deals.

Edwards and Magee, Technical Analysis of Stock Trends (AMACOM, 2007)

      This next definition of technical analysis tells us that it is a form of art, and its purpose is to identify a trend reversal as early as possible.

      The art of technical analysis, for it is an art, is to identify a trend reversal at a relatively early stage and ride on that trend until the weight of the evidence shows or proves that the trend has reversed.

Martin Pring, Technical Analysis Explained, 4th Edition (McGraw-Hill, 2002)

      The following definition is most relevant in the formulation of trading strategies. It reminds the market participants that nothing is certain and we must weigh our risk and returns.

      Technical analysis deals in probabilities, never in certainties.

Martin Pring, Technical Analysis Explained, 4th Edition (McGraw-Hill, 2002)

      The next statement gives a behavioral reason as to why technical analysis works.

      Technical analysis is based on the assumption that people will continue to make the same mistakes they have made in the past.

Martin Pring, Technical Analysis Explained, 4th Edition (McGraw-Hill, 2002)

      This definition by Pring stresses and underscores the point that there is a real reason and explanation as to why past price patterns tend to repeat. The tendency of price to repeat past patterns is mainly attributed to market participants repeating the same behavior. Although it is not impossible with sufficient and continuous conscious effort and strength of will, human beings rarely change their basic behavior, temperament, and deep-rooted biases, especially in relation to their emotional response to fear, greed, hope, anger, and regret when participating in the markets.

      The following statement about technical analysis explains its effectiveness in timing early entries and exits.

      Market price tends to lead the known fundamentals… Market price acts as a leading indicator of the fundamentals.

John Murphy, Technical Analysis of the Financial Markets (NYIF, 1999)

      This definition by Murphy highlights a very important assumption in technical analysis, which is that price is a reflection of all known information acted upon in the markets. It is the sum of all market participants’ trading and investment actions and decisions, including current and future expectations of market action. It also reflects the overall psychology, biases, and beliefs of all market participants. Therefore, the technical analysts believe that the charts tell the whole story and that everything that can or is expected to impact price has already been discounted. This assumption forms the very basis of technical analysis, and without it, technical analysis would be rendered completely pointless.

       Fundamental versus Technically Based Market Timing

      Before proceeding any further, it is best to briefly explain the meaning of a few commonly used terms in trading and technical analysis:

      • To go long means to buy to open a new position

      • To liquidate means to sell to close a position previously held

      • To go short means to sell to open a new position

      • To cover means to buy to close a position previously shorted

      Both fundamental and technically based market timing aim to satisfy the same basic principle of buying low and selling high. There are four basic scenarios where this may occur:

      1. Long at a low price and liquidate at a higher price

      2. Long at a relatively high price and liquidate at an even higher price

      3. Short at a high price and cover at a lower price

      4. Short at a relatively low price and cover at an even lower price

      Listed below are the some of the strengths of each approach with respect to timing the markets.g

       Technically Based Market Timing offers the ability to

      • Provide precise entry and exit prices

      • Provide the precise time of entry and exit

      • Provide real-time bullish and bearish signals

      • Provide real-time entry and exit price triggers

      • Scale in and out based on significant price levels

      • Time entries and exits based on volatility behavior of the underlying

      • Exit extended trends at technically significant price-reversal levels

      • Time entries and exits based on market order flow

      • Define percent risk in terms of significant price levels

      • Use volume and open interest analysis to gauge strength of an underlying move in order to time entries and exits

      • Use market breadth and broad market sentiment to gauge the strength of an underlying move in order to time entries and exits

      • Forecast potential peaks (for shorting or liquidating positions) as well as potential troughs (for getting long and covering positions) via the use of cycle and seasonality analysis

       Fundamentally Based Market Timing offers the ability to:

      • Gauge undervalued stocks with a potential to appreciate in value, but lacking information regarding the precise price or time to get long or to cover

      • Gauge overvalued stocks with a risk of depreciating in value, but lacking information regarding the precise price or time to get short or to liquidate

      • Screen and participate in fundamentally strong stocks in a sector or industry as part of an active asset allocation or rotation strategy, but lacking information regarding the precise price or time to get long

       The Fundamentalist versus Technical Analysts

      Listed below are some characteristics of the fundamentalist and technical analyst:

       The Fundamentalist:

      • Is mainly concerned with intrinsic value

      • Strives to understand the underlying causes for potential market moves

      • Is focused on which company to participate in

      • Can tell you which company to invest in, but cannot tell you the most advantageous moment to start participating in that stock

       The Technical Analyst:

      • Is mainly concerned with structure and dynamics of market and price action

      • Is more concerned with the effects of potential market moves rather than the cause of them

      • Cannot usually determine what the intrinsic value of an asset is or whether it is under-or overvalued, but is able to determine precisely when to start participating, purely from the perspective of price performance

      • Is not concerned with the underlying factors that led to the rise in price; this is irrelevant for all practical purposes as they believe that price is a reflection of all information available in the markets and therefore that is all that really matters

      In short, from what we have covered so far, we know that technical analysis:

      • Uses past information

      • Uses charts

      • Identifies past and current price action

      • Forecasts potential future price action based on historical price behavior (especially the start of a new trend)