Technical analysis has been in use within financial markets for over one hundred years. By definition, technical analysis is a trading discipline employed to evaluate investments and identify trading opportunities by analysing statistical trends gathered from trading activity, such as price movement and volume. Technical analysis provides a framework for informing investment management decisions by applying a supply and demand methodology to market prices.
Independent researchers have confirmed the value of technical analysis, beginning with the confirmation of the momentum anomaly. Momentum, or relative strength in the vernacular of technical analysts, has been applied since at least the 1930s. It is now widely accepted that relative strength analysis can help investment managers achieve statistically and economically significant excess returns. Additional research has confirmed the value of other technical tools, including pattern analysis, moving averages, and indicators.
This is diametrically opposed to fundamental analysis, which attempts to evaluate a security’s value based on business results such as sales and earnings. Practitioners of technical analysis, aptly named “technicians”, use tools in order to scrutinize the ways supply and demand for a security will affect changes in price, volume and implied volatility. Technical analysis is often used to generate short-term trading signals from various charting tools, but can also help improve the evaluation of a security’s strength or weakness relative to the broader market or one of its sectors.
Despite their differences, both technical analysis and fundamental analysis are considered to be valid tools in the consideration of analysis and portfolio management, and should be considered to be complimentary to one another in the investment process.
As information technology developed, so did the technical practices evolve too, with a number of different tools being more readily applied by a growing number of market participants. Furthermore, technical analysis developed from a purely visual analysis to more quantitative techniques. Like other analytical tools, technical analysis employs a disciplined, systematic approach that seeks to minimize the impact of behavioural biases and emotion from the practice of investment selection; consequently, many institutional analysts, strategists, and portfolio managers fuse technical research with other newer analytical approaches, such as quantitative and macroeconomic methods.
Advances in processing power and programming skills have allowed for objective testing of indicators and chart patterns. In recent years, quantitative analysis and behavioural finance have validated some of the techniques used by technical analysts. Standard financial theory has even embraced one of the most popular techniques: Relative strength analysis, which is closely related to the momentum anomaly in standard finance, although the difference in taxonomy may hide this relationship.
Despite this, criticisms remain over the validity of certain forms of technical analysis. The main issue that technicians face is the problem that the causal or empirical link between the observations and the forecasts is loose or absent. With the strength of modern computer power, this impediment has become easier to overcome, with automated analysis and tools for consistent verification and benchmarking; however a level of subjectivity remains.
The most important takeaway, even by professed technicians, is not to treat one individual indicator as a sure-fire bet on market direction, but as a part of a comprehensive analysis using several technical indicators, and combining it with fundamental principles and other quantitative and macroeconomic models.
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