Technical analysis monitors the historical price movements of securities to develop a variety of models and technical trading rules that estimate future market behavior. Unlike fundamental analysis which suggests that past performance has no influence on future performance, technical analysis focuses on price and volume changes, assuming that the market value of any security is determined exclusively by the interaction of supply and demand.
Technical Analysis Assumptions
Fundamental analysis agrees that the interaction of supply and demand determine the price of any security. However, the second assumption of technical analysis suggests that different rational and irrational factors drive supply and demand, including economic determinants of market corrections, but also factors such as opinions, moods, and guesses that shape the technical analysis trends. Therefore, for a market to be efficient, it has to automatically weigh all these factors and reflect them on the stock price.
The third assumption of technical analysis suggests that the prices of securities move in trends. These trends may persist for a prolonged period, and they adjust to changes in supply and demand. As new information enters the market, the prices of the stocks tend to absorb the information and reflect it on the stock price. The gradual pattern of information allows investors to buy or sell their stocks, thus moving the stock prices until the market reaches a new market equilibrium. In fact, technical analysis assumes that history repeats itself with respect to price movement as a result of investor psychology. Investors and market participants tend to react in the same way to similar market stimuli over time.
Technical Analysis Indicators
Technical analysis involves two main indicators. Leading indicators precede a price movement, and estimate the future movement, whereas lagging indicators follow and confirm a price movement. Leading indicators are strong in sideways markets, i.e. markets that have no clear upward or downward trend, whereas the lagging indicators are widely used upward or downward markets.
Other trends and momentum indicators are the 200-day moving average, the market breadth, the Average Directional Index (ADX) that measures the strength of a trend, the Moving Average Convergence Divergence (MACD) that measures the relationship between two moving averages of prices, and others.
Also, “follow the smart money” investments are also indicators of technical analysis because they follow the behavior of sophisticated investors who buy and sell the same security as institutional investors and/or market insiders. “Follow the smart money” investments tend to outperform other investments because institutional investors and insiders have better information than other investors.
In conclusion, technical analysis is used to analyze domestic and global capital markets as well as forex markets seeking to estimate how investors are expected to behave in the future. Many technical analysts assume that investors are wrong as the market approaches peaks and lows and seek to determine when investors are either bearish or bullish to make aggregate market decisions based on rising and declining trend channels.
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