Technical analysis is the study of charts. More specifically, it is the study of price versus time. Regardless of your view of the markets, price is the ultimate reality for traders, it is the sum of all fears and all hopes. If we truly believe that the market is always right, then the study of price is the purest form of analysis. Unlike fundamental analysis, which is the study of value, there is no subjectivity with price – it’s there for all to see.
Given that price data is made available to all market participants, either free or for a common price by securities exchanges, we are faced with a level playing field for all participants. The wealthiest and most powerful individuals in the world have absolutely no advantage over the smallest traders in obtaining prices and analysing them.
Can the same be said with fundamental analysis? Does everyone have the same access to company information? Despite the best efforts of securities exchanges and government regulators, history shows us that not all market participants transact based upon the same information. Not all market participants get their market information at the same time and therefore some investors have a significant advantage over others.
Company insiders obviously have the best information regarding companies and how they are performing. There are specific times when these company insiders can legally transact in the shares of their companies and all transactions must be fully disclosed to the exchange. In a perfect world, the proverbial buck would stop here, but those who are close to company insiders including family and friends often benefit from leakage of price sensitive company information. This can often be the source of rumours and tips which can spread quite a way through the investment community.
Next best informed are the research analysts at the big broking firms, which as part of their routine, will talk to company insiders, visit company operations, and analyse in painful detail any information put out by the company to the rest of the market. Research analysts’ perceptions of value will determine how much capital is applied to various companies shares either through buying and selling on behalf of their brokerage firms, or by influencing clients to buy or sell.
It is probably fair to say that both of the above parties have a major advantage over the average ‘mum and dad’ investor when it comes to accessing and capitalising on fundamental information.
Fortunately, regardless of who has the market sensitive information, and when they’ve obtained that information relative to other participants, there’s only one alternative should they feel strongly enough to act upon that information: They need to transact! This will either create supply or demand for the security in question. The interaction of this supply with demand results in price realisation. Prices therefore reflect all of the information available to all participants, official or unofficial. They level the playing field for all investors.
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A chart is simply a schedule of price versus time. Price is plotted on the vertical axis and time is plotted on the horizontal axis. We will talk in detail about each of these factors in this and future Marketpulse articles, and investigate how traders can use clues from price and time to predict where price may be headed in the future. This is otherwise known as the study of technical analysis.
There are four important elements of the price which are regularly represented on charts, they are: the opening price, the high price, the low price, and the closing price or Open, High, Low, and Close. This data is logged for a certain period we wish to analyse and then gathered for all previous and subsequent periods to make a price schedule or chart.
There are a number of different ways to represent price on a chart:
In this type of chart, each period’s closing price is joined up in a continuous line. Line charts ignore other elements of price data such as open, high and low and only focus on the close. This cuts out much of the volatility which can occur intraday and therefore a great deal of “noise” associated with price action. Line charts are good for getting an overall picture of the trend of a stock. The trend is the most important indicator of potential future price movement.
In this type of chart, each period’s closing price is represented as a line or a “bar”. The bar’s high point will match the highest price the security trade at during the period and its low point will be the lowest price the security traded at during the period. It is common for bar charts to also have horizontal dashes to represent the open (drawn to the left of the bar) and the close prices (drawn to the right of the bar) for the period.
A candlestick chart is similar to a bar chart in that it considers the open, high, low and closing prices for each trading period, but represents this data in a slightly different way. Each period is represented by a coloured box. The box is formed by measuring difference between the opening and closing prices for the period. If the price has fallen for the period, the box is coloured black. If the price has risen for the period, the price is coloured white.
If the price rises or falls outside the range between the opening and closing prices, then the movement is represented as a line protruding from the box part of the candle. Another name for the box part is the “real body” of the candle. The lines protruding from the real body are known as “shadows” or “wicks”.
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Why technical analysis?
Charts essentially perform one simple task for the astute trader: to explain the interaction between supply and demand for an asset’s securities. All investors, whether from a fundamental or technical background must agree on one inarguable point: the interaction of supply and demand for the asset’s securities moves its price.
If there is a greater demand for the asset’s securities than supply, then price must rise. If there is a greater supply of the asset’s securities than the demand, then the price must fall.
Despite this inescapable fact of the markets, fundamental analysts insist on focussing on the drivers of supply and demand for the company’s products and services, rather than for its securities on the market. From the expected supply and demand for the company’s products and services, they attempt to forecast future cash flows and profits. From these forecasts, they then attempt to derive a perceived value for the company’s shares.
If their perceived value is lower than the present market price of the security, the analyst will recommend that their firm and its clients buy the security in question. The assumption here is that the market will eventually realise its mistake and other investors will push up the price of the security to match the analyst’s correct prediction of value.
Conversely, if the analyst’s perceived value is less than the present market price, they will recommend a sell. In this case they are betting that the market will realise how silly it is to be paying such a high price for the security in question, and mark down its value until it once again matches the analyst’s astute view.
This is of course a ridiculous notion – that the market cares two hoots about what the analyst, or any individual for that matter, thinks!
The fundamental analyst, by focussing on supply and demand for the company’s products and services has failed to understand that this balance matters far less for making money in the markets, than an understanding of the supply and demand for the company’s shares. One cannot argue that the only way to make money from a security’s purchase is to have the price of the security move in your favour after you transact. So if price is everything for making money in the markets, then focus only on how that price is derived – through supply and demand!
Regardless of how fantastic the fundamental analyst believes a particular security to be, if there is little demand for the security’s shares from other parties, and too much supply from non-believers, then the price will not go up and the fundamental analyst will not profit from purchasing those shares.
Technical analysts are not so arrogant as to believe that the market will heed their will. Further, they form no views about the worth or value of a security outside of what is possible based upon the likely supply and demand for the security on the market. Technical analysts are disciples of price as the ultimate reality and therefore have a major tactical and psychological advantage over fundamental analysts.
We’ll explore the concepts of technical analysis further in next week’s Marketpulse.
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