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Required Background for Learning Technical Analysis

Michael N. Kahn explains technical market theory and the pillars of technical analysis.
This chapter is from the book

As much as it would be good to jump right into learning technical analysis, it is still a good idea to understand some broad concepts.

The Past

  • "Those who cannot remember the past are condemned to repeat it."
  • —George Santayana

Historical Data

When investment professionals as a group make their decisions, they often analyze such fundamental information as economics, politics, and demographics. They look back to the past to forecast what may happen in the future. This does not mean that they are consulting a magic oracle but rather, they are employing technical analysis of the markets. This discipline relies on generous amounts of historical price data that is both accurate and readily available to their computer applications.

Technical analysis is based on human behavior, but it is not a study in psychology. Investors and speculators react the same way to the same types of events again and again, and this is reflected in the ebb and flow of prices. If one charts this activity over time, patterns in the price action emerge. Some of these patterns comprise standard technical analysis, while others are created by analysts based on their own observations and calculations. Historical data are required in both cases to test theories and fine tune their parameters.

When currency traders, for example, are deciding whether or not to buy yen, they may look at a chart of yen prices for the past year to determine if the recent rally has ended. This graphical representation makes it a quick study. By expanding the chart to cover more years, they can quickly find other occasions when the yen rose quickly and what happened just after it did.

History Repeats

Technical price patterns are often followed by similar reactions. For example, if prices were rising and then start to trade in a small range, the characteristics (shape and size) of the range can be used to determine how far the market will move once the pattern is ended. This is not just a guess, but a highly likely condition (reaction by humans) based on thousands of similar occurrences in the past. The more historical data the investor has available, the more historical observations can be made and the more likely the investor will make a correct buy or sell decision.

The biggest advantage to using a historical database in making these decisions is that it gives the trader or analyst perspective. A sharp price increase in one commodity today may be taken as a bullish sign until it is viewed as part of a longer chart that has been declining for the past six months. In that light, the rally in a commodity may well be an opportunity to unload it rather than load up on it.

One of the biggest criticisms is that technical analysis is a self-fulfilling prophecy. Wearing a "making money, not forecasts" hat sounds like a good deal for those who get in early. Stepping back from the profits for a moment, it should be conceded that the criticism is true in some cases.

One definition of a technical breakout says that a market that moves above the top of a technical pattern should be bought. Short-term traders who see this buy, and the market moves higher due to increased demand.

This works well on the initial breakout as new buyers are drawn in. However, unless there are more technical factors supporting the move, the rally will fail. In this case, the prophecy will not come true. For a sustained rally, there must be increasing demand and increasing participation from the public (individual or institutional). True breakouts are usually presaged by changes in the underlying technical condition, have certain confirming characteristics at the breakout, and are followed by improving technical indications.

Although this undermines the self-fulfilling prophecy argument, rallies, chart patterns, and breakouts can all be measured and followed because people do repeat their actions. A triangle pattern in today's market is formed for many of the same reasons that it was formed before. A breakout now will probably create the same result.

History repeats itself in the same way that snowflakes look alike. From a distance, they look the same. When put under the microscope, however, the differences become apparent. In the markets, human participants tend to do similar things given similar circumstances. For example, if a rally stalls and a triangle pattern forms on the charts, buyers and sellers become increasingly uncertain about what to do. They buy and sell with less confidence as they wait for some outside influence to spark the next move, higher or lower. The fact that there are at least five different variations of triangles tells us that these periods of increasing uncertainty are not exactly alike.

What does a budding technician make of all this? Following the basic rules of market behavior will be profitable most of the time, and we must be nimble enough to react when events deviate from the expected.

This summarizes the similarity of market actions without locking us into strict definitions. People tend to do similar things given similar conditions. We learn from our mistakes. However, there are always new people entering the market who have not yet had their lessons.

Repetition and Rhyming

Are no two snowflakes exactly alike? Does lightning ever strike twice? Does a bull market last the same time and move the same distance?

It was Mark Twain who said, "History does not repeat itself. But it does rhyme." No matter how much today's market may look like a previous market, you cannot be 100% sure it will continue to react in the same way. It may go up, but not as fast. It may pause to rest in a quiet trading range, or it may pause to rest in a volatile trading range.

With so many variables that can affect the market, the difference between having 80 and 90% of them in line probably does not matter to a bottom-line decision of buy, sell, or hold. It might affect the course or amount of the rally, but not the decision to buy or sell.

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