I buy today? What will prices be tomorrow, next
week, or next year? Wouldn't investing be easy
if we knew the answers to these seemingly simple
questions? Alas, if you are reading this book
in the hope that technical analysis has the
answers to these questions, I'm afraid I have
to disappoint you early--it doesn't. However,
if you are reading this book with the hope that
technical analysis will improve your investing,
I have good news--it will!
term "technical analysis" is a complicated
sounding name for a very basic approach to investing.
Simply put, technical analysis is the study
of prices, with charts being the primary tool.
roots of modern-day technical analysis stem
from the Dow Theory, developed around 1900 by
Charles Dow. Stemming either directly or indirectly
from the Dow Theory, these roots include such
principles as the trending nature of prices,
prices discounting all known information, confirmation
and divergence, volume mirroring changes in
price, and support/resistance. And of course,
the widely followed Dow Jones Industrial Average
is a direct offspring of the Dow Theory.
Dow's contribution to modern-day technical analysis
cannot be understated. His focus on the basics
of security price movement gave rise to a completely
new method of analyzing the markets.
The human element
price of a security represents a consensus.
It is the price at which one person agrees to
buy and another agrees to sell. The price at
which an investor is willing to buy or sell
depends primarily on his expectations. If he
expects the security's price to rise, he will
buy it; if the investor expects the price to
fall, he will sell it. These simple statements
are the cause of a major challenge in forecasting
security prices, because they refer to human
expectations. As we all know firsthand, humans
are not easily quantifiable nor predictable.
This fact alone will keep any mechanical trading
system from working consistently.
humans are involved, I am sure that much of
the world's investment decisions are based on
irrelevant criteria. Our relationships with
our family, our neighbors, our employer, the
traffic, our income, and our previous success
and failures, all influence our confidence,
expectations, and decisions.
prices are determined by money managers and
home managers, students and strikers, doctors
and dog catchers, lawyers and landscapers, and
the wealthy and the wanting. This breadth of
market participants guarantees an element of
unpredictability and excitement.
we were all totally logical and could separate
our emotions from our investment decisions,
then, fundamental analysis the determination
of price based on future earnings, would work
magnificently. And since we would all have the
same completely logical expectations, prices
would only change when quarterly reports or
relevant news was released. Investors would
seek "overlooked" fundamental data
in an effort to find undervalued securities.
hotly debated "efficient market theory"
states that security prices represent everything
that is known about the security at a given
moment. This theory concludes that it is impossible
to forecast prices, since prices already reflect
everything that is currently known about the
The future can be found
in the past
prices are based on investor expectations, then
knowing what a security should sell for (i.e.,
fundamental analysis) becomes less important
than knowing what other investors expect it
to sell for. That's not to say that knowing
what a security should sell for isn't important--it
is. But there is usually a fairly strong consensus
of a stock's future earnings that the average
investor cannot disprove.
believe the future is only the past again, entered through another gate."
- Sir Arthur Wing Pinero, 1893
analysis is the process of analyzing a security's
historical prices in an effort to determine
probable future prices. This is done by comparing
current price action (i.e., current expectations)
with comparable historical price action to predict
a reasonable outcome. The devout technician
might define this process as the fact that history
repeats itself while others would suffice to
say that we should learn from the past.
The roulette wheel
my experience, only a minority of technicians
can consistently and accurately determine future
prices. However, even if you are unable to accurately
forecast prices, technical analysis can be used
to consistently reduce your risks and improve
best analogy I can find on how technical analysis
can improve your investing is a roulette wheel.
I use this analogy with reservation, as gamblers
have very little control when compared to investors
(although considering the actions of many investors,
gambling may be a very appropriate analogy).
"There are two times
in a man's life when he should not speculate: when he can't afford it, and when
- Mark Twain, 1897
casino makes money on a roulette wheel, not
by knowing what number will come up next, but
by slightly improving their odds with the addition
of a "0" and "00."
when an investor purchases a security, he doesn't
know that its price will rise. But if he buys
a stock when it is in a rising trend, after
a minor sell off, and when interest rates are
falling, he will have improved his odds of making
a profit. That's not gambling--it's intelligence.
Yet many investors buy securities without attempting
to control the odds.
to popular belief, you do not need to know what
a security's price will be in the future to
make money. Your goal should simply be to improve
the odds of making profitable trades. Even if
your analysis is as simple as determining the
long-, intermediate-, and short-term trends
of the security, you will have gained an edge
that you would not have without technical analysis.
the chart of Merck in Figure 1 where the trend
is obviously down and there is no sign of a
reversal. While the company may have great earnings
prospects and fundamentals, it just doesn't
make sense to buy the security until there is
some technical evidence in the price that this
trend is changing.
If we accept the fact that
human emotions and expectations play a role in security pricing, we should also
admit that our emotions play a role in our decision making. Many investors try
to remove their emotions from their investing by using computers to make
decisions for them. The concept of a "HAL," the intelligent computer
in the movie 2001, is appealing.
trading systems can help us remove our emotions
from our decisions. Computer testing is also
useful to determine what has happened historically
under various conditions and to help us optimize
our trading techniques. Yet since we are analyzing
a less than logical subject (human emotions
and expectations), we must be careful that our
mechanical systems don't mislead us into thinking
that we are analyzing a logical entity.
is not to say that computers aren't wonderful
technical analysis tools--they are indispensable.
In my totally biased opinion, technical analysis
software has done more to level the playing
field for the average investor than any other
non-regulatory event. But as a provider of technical
analysis tools, I caution you not to let the
software lull you into believing markets are
as logical and predictable as the computer you
use to analyze them.