Home > Articles > Business & Management > Finance & Investing

Introduction to Technical Analysis

  • Print
  • + Share This
The authors of Technical Analysis introduce their book, which thoroughly addresses recent advances in pattern recognition, market analysis, systems management, and confidence testing; Kagi, Renko, Kase, Ichimoku, Clouds, and DeMark indicators; innovations in exit stops, portfolio selection, and testing; implications of behavioral bias, and the recent performance of old formulas and methods.
This chapter is from the book

Technical analysis—these words may conjure up many different mental images. Perhaps you think of the stereotypical technical analyst, alone in a windowless office, slouched over stacks of hand-drawn charts of stock prices. Maybe you think of the sophisticated multicolored computerized chart of your favorite stock you recently saw. Possibly you think of a proprietary trader in front of multiple computer screens displaying graphics of each trade in a series of futures markets. Perhaps you begin dreaming about all the money you could make if you knew the secrets to predicting stock prices. Or, maybe you remember sitting in a finance class and hearing your professor say that technical analysis “is a waste of time.” In this book, we examine some of the perceptions and misperceptions of technical analysis.

If you are new to the study of technical analysis, you might be wondering just what technical analysis is. In its basic form, the answer is that technical analysis is the study of prices in freely traded markets with the intent of making profitable trading or investment decisions. Technical analysis is rooted in basic economic theory. Consider the assumptions presented by Robert D. Edwards and John Magee in the classic book Technical Analysis of Stock Trends:

  • Stock prices are determined solely by the interaction of demand and supply.
  • Stock prices tend to move in trends.
  • Shifts in demand and supply cause reversals in trends.
  • Shifts in demand and supply can be detected in charts.
  • Chart patterns tend to repeat themselves.

Technical analysts study the action of the markets rather than of the goods in which the market deals. The technical analyst believes that “the market is always correct.” In other words, rather than trying to consider all the factors that will influence the demand for Gadget International’s newest electronic gadget and all the items that will influence the company’s cost and supply curve to determine an outlook for the stock’s price, the technical analyst believes that all these factors are already factored into the demand and supply curves and, thus, the price of the company’s stock. We find that stock prices (and prices for any security in freely traded markets) are influenced by psychological factors as well, most of them indecipherable. Greed, fear, cognitive bias, misinformation, expectations, and other factors enter into the price of a security, making the analysis of the factors nearly impossible. The technical analyst disregards all these imponderables and instead studies the way the marketplace is accepting the multitude of exogenous information and beliefs with the intention of finding patterns in that action that have predictive potential.

Students new to any discipline often ask, “How can I use the knowledge of this discipline?” Students new to technical analysis are no different. Technical analysis is used in two major ways: predictive and reactive. Those who use technical analysis for predictive purposes use the analysis to make predictions about future market moves. Generally, these individuals make money by selling their predictions to others. Market letter writers in print or on the Web and the technical market gurus who frequent the financial news fall into this category. The predictive technical analysts include the more well-known names in the industry; these individuals like publicity because it helps market their services.

On the other hand, those who use technical analysis in a reactive mode are usually not well known. Traders and investors use techniques of technical analysis to react to particular market conditions to make their decisions. For example, a trader may use a moving average crossover to signal when a long position should be taken. In other words, the trader is watching the market and reacting when a certain technical condition is met. These traders and investors are making money by making profitable trades for their own or clients’ portfolios. Some of them may even find that publicity distracts them from their underlying work.

The focus of this book is to explain the basic principles and techniques of technical analysis. We do not attempt to predict the market, nor do we provide you with the Holy Grail or a promise of a method that will make you millions overnight. Instead, we offer background, basic tools, and techniques that you will need to be a competent, reactive, technical analyst.

As we will see when we study the history of technical analysis, the interest in technical analysis in the United States dates back more than 150 years, when Charles H. Dow began to write newsletters that later turned into the Wall Street Journal and developed the various Dow averages to measure the stock market. Since that time, much has been written about technical analysis. Today, there are entire periodicals, such as the Technical Analysis of Stock and Commodities and the Journal of Technical Analysis, devoted to the study of the subject. In addition, there are many articles appearing in other publications, including academic journals. There are even a number of excellent books on the market. As you can see from this book’s extensive bibliography, which is in no way a complete list of every published item on technical analysis, a massive quantity of material about technical analysis exists.

So why does the world need another book on technical analysis? We began looking through the multitude of materials on technical analysis a few years ago, searching for resources to use in educational settings. We noticed that many specialized books existed on the topic, but there was no resource to provide the student of technical analysis with a comprehensive summation of the body of knowledge. We decided to supply a coherent, logical framework for this material that could be used as a textbook and a reference book.

Our intent in writing this book is to provide the student of technical analysis, whether a novice college student or an experienced practitioner, with a systematic study of the field of technical analysis. Over the past century, much has been written about the topic. The classic works of Charles Dow and the timeless book by Edwards and Magee still contain valuable information for the student of technical analysis. The basic principles of these early authors are still valid today. However, the evolving financial marketplace and the availability of computer power have led to a substantial growth in the new tools and information available to the technical analyst.

Many technical analysts learned their trade from the mentors with whom they have worked. Numerous individuals who are interested in studying technical analysis today, however, do not have access to such a mentor. In addition, as the profession has advanced, many specific techniques have been developed. The result is that the techniques and methods of technical analysis often appear to be a hodgepodge of tools, ideas, and even folklore, rather than a part of a coherent body of knowledge.

Many books on the market assume a basic understanding of technical analysis or focus on particular financial markets or instruments. Our intent is to offer the reader a basic reference to support a lifelong study of the discipline. We have attempted to provide enough background information and terminology that you can easily read this book without having to refer to other references for background information. We have also included a large number of references for further reading so that you can continue learning in the specialized areas that interest you.

Another unique characteristic of this book is the joining of the practitioner and the academic. Technical analysis is widely practiced, both by professional traders and investors and by individuals managing their own money. However, this widespread practice has not been matched by academic acknowledgment of the benefits of technical analysis. Academics have been slow to study technical analysis; most of the academic studies of technical analysis have lacked a thorough understanding of the actual practice of technical analysis. It is our hope not only to bring together a practitioner-academic author team but also to provide a book that promotes discussion and understanding between these two groups.

Whether you are a novice or an experienced professional, we are confident that you will find this book helpful. For the student new to technical analysis, this book will give you the basic knowledge and building blocks to begin a lifelong study of technical analysis. For the more experienced technician, you will find this book to be an indispensable guide, helping you to organize your knowledge, question your assumptions and beliefs, and implement new techniques.

We begin this book with a look at the background and history of technical analysis. In Part I, “Introduction,” we discuss not only the basic principles of technical analysis but also the technical analysis controversy—the debate between academics and practitioners regarding the efficiency of financial markets and the merit of technical analysis. This background information is especially useful to those who are new to technical analysis and to those who are studying the subject in an educational setting. For those with more experience with the field or with little interest in the academic arguments about market efficiency, a quick reading of this first part will probably suffice.

In Part II, “Markets and Market Indicators,” we focus on markets and market indicators. Chapter 5, “An Overview of Markets,” is a basic overview of how markets work. Market vocabulary and trading mechanics are introduced in this chapter. For the student who is unfamiliar with this terminology, a thorough understanding of this chapter will provide the necessary background for the remaining chapters. Our focus in Chapter 6, “Dow Theory,” is on the development and principles of Dow Theory. Although Dow Theory was developed a century ago, much of modern-day technical analysis is based on these classic principles. A thorough understanding of these timeless principles helps keep the technical analyst focused on the key concepts that lead to making money in the market. In Chapter 7, “Sentiment,” the psychology of market players is a major concept. In Chapter 8, “Measuring Market Strength,” we discuss methods for gauging overall market strength. In Chapter 9, “Temporal Patterns and Cycles,” we focus on temporal tendencies, the tendency for the market to move in particular directions during particular times, such as election year cycles and seasonal stock market patterns. Because the main fuel for the market is money, Chapter 10, “Flow of Funds,” looks at measures of market liquidity and how the Federal Reserve can influence that liquidity.

Part III, “Trend Analysis,” can be thought of as the heart of technical analysis. If we see that the market is trending upward, we can profitably ride that trend upward. If we determine that the market is trending downward, we can even profit by taking a short position. In fact, the most difficult time to profit in the market is when there is no definitive upward or downward trend. Over the years, technical analysts have developed a number of techniques to help them visually determine when a trend is in place. These charting techniques are the focus of Chapter 11, “History and Construction of Charts.” In Chapter 12, “Trends—The Basics,” we discuss how to draw trend lines and determine support and resistance lines using these charts. In Chapter 13, “Breakouts, Stops, and Retracements,” we focus on determining breakouts. These breakouts will help us recognize a trend change as soon as possible. Moving averages, a useful mathematical technique for determining the existence of trends, are presented in Chapter 14, “Moving Averages.”

Part IV, “Chart Pattern Analysis,” focuses on the item that first comes to mind when many people think of technical analysis. In Chapter 15, “Bar Chart Patterns,” we cover classic bar chart patterns; in Chapter 16, “Point and Figure Chart Patterns,” we focus on point and figure chart patterns. Finally, short-term patterns, including candlestick patterns, are covered in Chapter 17, “Short-Term Patterns.”

Part V, “Trend Confirmation,” deals with the concept of confirmation. We consider price oscillators and momentum measures in Chapter 18, “Confirmation.” Building upon the concept of trends from earlier chapters, we look at how volume plays a role in confirming the trend, giving us more confidence that a trend is indeed occurring. We also look at oscillators and indexes of momentum to analyze other means of confirming price trend.

Next, we turn our attention to the relationship between cycle theory and technical analysis in Part VI, “Other Technical Methods and Rules.” In Chapter 19, “Cycles,” we discuss the basic principles of cycle theory and the characteristics of cycles. Some technical analysts believe that cycles seen in the stock market have a scientific basis; for example, R. N. Elliott claimed that the basic harmony found in nature occurs in the stock market. Chapter 20, “Elliott, Fibonacci, and Gann,” introduces the basic concepts of Elliott Wave Theory, a school of thought that adheres to Elliott’s premise that stock price movements form discernible wave patterns.

Once we know the basic techniques of technical analysis, the question becomes, “Which particular securities will we trade?” covered in Part VII, “Selection.” Selection decisions are the focus of Chapter 21, “Selection of Markets and Issues: Trading and Investing.” In this chapter, we discuss the intermarket relationships that will help us determine on which market to focus by determining which market is most likely to show strong performance. We also discuss individual security selection, measures of relative strength, and how successful practitioners have used these methods to construct portfolios.

As technical analysts, we need methods of measuring our success. After all, our main objective is making money. Although this is a straightforward objective, determining whether we are meeting our objective is not quite so straightforward. Proper measurement of trading and investment strategies requires appropriate risk measurement and an understanding of basic statistical techniques. That’s where Part VIII, “System Testing and Management,” comes into play. The last couple of chapters help put all the tools and techniques we present throughout the book into practice. Chapter 22, “System Design and Testing,” is devoted to developing and testing trading systems. At this point, we look at how we can test the tools and indicators covered throughout the book to see if they will make money for us—our main objective—in the particular way we would like to trade. Finally, Chapter 23, “Money and Portfolio Risk Management,” deals with “stops” to protect individual investments from loss and with money management to avoid overall capital loss.

For those who need a brushup in basic statistics or want to understand some of the statistical concepts introduced throughout the book, Richard J. Bauer, Jr., Ph.D., CFA, CMT (Professor of Finance, Greehey School of Business, St. Mary’s University, San Antonio, Texas), provides a tutorial on basic statistical techniques of interest to the technical analyst in Appendix A, “Basic Statistics.”

For those who are unfamiliar with the terms and language used in trading, Appendix B, “Types of Orders and Other Trader Terminology,” offers brief definitions of specific order types and commonly used terms in order entry.

A comprehensive bibliography positioned before the index at the back of the book provides not only historic reading references but also contemporary studies by academic institutions as well as recent books and articles on various aspects of technical analysis both practical and theoretical.

As with all skills, learning technical analysis requires practice. We have supplied a number of review questions and problems at the end of the chapters to help you begin thinking about and applying some of the concepts on your own. (A study guide, available separately, provides the answers to the questions.) The extensive bibliography will direct you to further readings in the areas of technical analysis that are of particular interest to you.

Another way of honing your technical skills is by participating in a professional organization that is focused on technical analysis. In the United States, the Market Technicians Association (MTA) provides a variety of seminars, lectures, and publications for technical analysis professionals. It has 23 U.S. and 16 foreign chapters, three levels of membership (student, affiliate, and full), and a well-stocked library of technical analysis books and other publications. The MTA also sponsors the Chartered Market Technician (CMT) program. Professionals wanting to receive the prestigious CMT designation must pass three examinations and adhere to a strict code of professional conduct. More information about the MTA and the CMT program may be found at the Web site www.mta.org. The International Federation of Technical Analysts, Inc. (IFTA) is a global organization of market analysis societies and associations. IFTA and its 21 member associations worldwide sponsor a number of seminars and publications. IFTA offers a professional certification, the Certified Financial Technician (CFTe), and a masters-level degree, the Master of Financial Technical Analysis (MFTA). The details of these certifications, along with contact information for IFTA’s member associations around the world, can be found at their Web site: www.ifta.org.

Technical analysis is a complex, ever-expanding discipline. The globalization of markets, the creation of new securities, and the availability of inexpensive computer power are opening even more opportunities in this field. Whether you use the information professionally or for your own personal trading or investing, we hope that this book will serve as a stepping-stone to your study and exploration of the field of technical analysis.

  • + Share This
  • 🔖 Save To Your Account

InformIT Promotional Mailings & Special Offers

I would like to receive exclusive offers and hear about products from InformIT and its family of brands. I can unsubscribe at any time.

Overview


Pearson Education, Inc., 221 River Street, Hoboken, New Jersey 07030, (Pearson) presents this site to provide information about products and services that can be purchased through this site.

This privacy notice provides an overview of our commitment to privacy and describes how we collect, protect, use and share personal information collected through this site. Please note that other Pearson websites and online products and services have their own separate privacy policies.

Collection and Use of Information


To conduct business and deliver products and services, Pearson collects and uses personal information in several ways in connection with this site, including:

Questions and Inquiries

For inquiries and questions, we collect the inquiry or question, together with name, contact details (email address, phone number and mailing address) and any other additional information voluntarily submitted to us through a Contact Us form or an email. We use this information to address the inquiry and respond to the question.

Online Store

For orders and purchases placed through our online store on this site, we collect order details, name, institution name and address (if applicable), email address, phone number, shipping and billing addresses, credit/debit card information, shipping options and any instructions. We use this information to complete transactions, fulfill orders, communicate with individuals placing orders or visiting the online store, and for related purposes.

Surveys

Pearson may offer opportunities to provide feedback or participate in surveys, including surveys evaluating Pearson products, services or sites. Participation is voluntary. Pearson collects information requested in the survey questions and uses the information to evaluate, support, maintain and improve products, services or sites, develop new products and services, conduct educational research and for other purposes specified in the survey.

Contests and Drawings

Occasionally, we may sponsor a contest or drawing. Participation is optional. Pearson collects name, contact information and other information specified on the entry form for the contest or drawing to conduct the contest or drawing. Pearson may collect additional personal information from the winners of a contest or drawing in order to award the prize and for tax reporting purposes, as required by law.

Newsletters

If you have elected to receive email newsletters or promotional mailings and special offers but want to unsubscribe, simply email information@informit.com.

Service Announcements

On rare occasions it is necessary to send out a strictly service related announcement. For instance, if our service is temporarily suspended for maintenance we might send users an email. Generally, users may not opt-out of these communications, though they can deactivate their account information. However, these communications are not promotional in nature.

Customer Service

We communicate with users on a regular basis to provide requested services and in regard to issues relating to their account we reply via email or phone in accordance with the users' wishes when a user submits their information through our Contact Us form.

Other Collection and Use of Information


Application and System Logs

Pearson automatically collects log data to help ensure the delivery, availability and security of this site. Log data may include technical information about how a user or visitor connected to this site, such as browser type, type of computer/device, operating system, internet service provider and IP address. We use this information for support purposes and to monitor the health of the site, identify problems, improve service, detect unauthorized access and fraudulent activity, prevent and respond to security incidents and appropriately scale computing resources.

Web Analytics

Pearson may use third party web trend analytical services, including Google Analytics, to collect visitor information, such as IP addresses, browser types, referring pages, pages visited and time spent on a particular site. While these analytical services collect and report information on an anonymous basis, they may use cookies to gather web trend information. The information gathered may enable Pearson (but not the third party web trend services) to link information with application and system log data. Pearson uses this information for system administration and to identify problems, improve service, detect unauthorized access and fraudulent activity, prevent and respond to security incidents, appropriately scale computing resources and otherwise support and deliver this site and its services.

Cookies and Related Technologies

This site uses cookies and similar technologies to personalize content, measure traffic patterns, control security, track use and access of information on this site, and provide interest-based messages and advertising. Users can manage and block the use of cookies through their browser. Disabling or blocking certain cookies may limit the functionality of this site.

Do Not Track

This site currently does not respond to Do Not Track signals.

Security


Pearson uses appropriate physical, administrative and technical security measures to protect personal information from unauthorized access, use and disclosure.

Children


This site is not directed to children under the age of 13.

Marketing


Pearson may send or direct marketing communications to users, provided that

  • Pearson will not use personal information collected or processed as a K-12 school service provider for the purpose of directed or targeted advertising.
  • Such marketing is consistent with applicable law and Pearson's legal obligations.
  • Pearson will not knowingly direct or send marketing communications to an individual who has expressed a preference not to receive marketing.
  • Where required by applicable law, express or implied consent to marketing exists and has not been withdrawn.

Pearson may provide personal information to a third party service provider on a restricted basis to provide marketing solely on behalf of Pearson or an affiliate or customer for whom Pearson is a service provider. Marketing preferences may be changed at any time.

Correcting/Updating Personal Information


If a user's personally identifiable information changes (such as your postal address or email address), we provide a way to correct or update that user's personal data provided to us. This can be done on the Account page. If a user no longer desires our service and desires to delete his or her account, please contact us at customer-service@informit.com and we will process the deletion of a user's account.

Choice/Opt-out


Users can always make an informed choice as to whether they should proceed with certain services offered by InformIT. If you choose to remove yourself from our mailing list(s) simply visit the following page and uncheck any communication you no longer want to receive: www.informit.com/u.aspx.

Sale of Personal Information


Pearson does not rent or sell personal information in exchange for any payment of money.

While Pearson does not sell personal information, as defined in Nevada law, Nevada residents may email a request for no sale of their personal information to NevadaDesignatedRequest@pearson.com.

Supplemental Privacy Statement for California Residents


California residents should read our Supplemental privacy statement for California residents in conjunction with this Privacy Notice. The Supplemental privacy statement for California residents explains Pearson's commitment to comply with California law and applies to personal information of California residents collected in connection with this site and the Services.

Sharing and Disclosure


Pearson may disclose personal information, as follows:

  • As required by law.
  • With the consent of the individual (or their parent, if the individual is a minor)
  • In response to a subpoena, court order or legal process, to the extent permitted or required by law
  • To protect the security and safety of individuals, data, assets and systems, consistent with applicable law
  • In connection the sale, joint venture or other transfer of some or all of its company or assets, subject to the provisions of this Privacy Notice
  • To investigate or address actual or suspected fraud or other illegal activities
  • To exercise its legal rights, including enforcement of the Terms of Use for this site or another contract
  • To affiliated Pearson companies and other companies and organizations who perform work for Pearson and are obligated to protect the privacy of personal information consistent with this Privacy Notice
  • To a school, organization, company or government agency, where Pearson collects or processes the personal information in a school setting or on behalf of such organization, company or government agency.

Links


This web site contains links to other sites. Please be aware that we are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of each and every web site that collects Personal Information. This privacy statement applies solely to information collected by this web site.

Requests and Contact


Please contact us about this Privacy Notice or if you have any requests or questions relating to the privacy of your personal information.

Changes to this Privacy Notice


We may revise this Privacy Notice through an updated posting. We will identify the effective date of the revision in the posting. Often, updates are made to provide greater clarity or to comply with changes in regulatory requirements. If the updates involve material changes to the collection, protection, use or disclosure of Personal Information, Pearson will provide notice of the change through a conspicuous notice on this site or other appropriate way. Continued use of the site after the effective date of a posted revision evidences acceptance. Please contact us if you have questions or concerns about the Privacy Notice or any objection to any revisions.

Last Update: November 17, 2020