Saturday, March 27, 2010

Philosophy of Technical Analysis

As you have probably have noticed by now, I primarily use technical analysis as my market analysis methodology. I believe technical analysis is superior to fundamental analysis because "fundamentally" it's all about supply and demand. What better way to understand the supply and demand than studying price and volume action using charts. The major flaw with fundamental analysis is that information is with held from the public until it's too late. Only after the insiders and big money has acted upon the information is it then released to the public. How many times have you asked yourself, why is the stock market going down when the "fundamentals" are good (based on the news) or vice versa. That's why I say ignore the news because it is simply distracting and misleading. You can tell if the stock market is bearish or bullish simply by looking at a chart. Have you ever heard this one before : "the stock market leads the economy" or "the stock market is a leading indicator of the economy". For example, why is the stock market going up when the news says the fundamentals for the economy are poor? Who cares why. The bottom line is the bottom line. I recommend everyone read the following book by John Murphy: Technical Analysis of the Financial Markets: A Comprehensive Guide to Trading Methods and Applications (New York Institute of Finance)

Here's some key take aways from Chapter 1, titled "Philosophy of Technical Analysis". Technical analysis is defined as the study of market action, primarily through the use of charts, for the purpose of forecasting price trends. Market action includes price, volume, and open interest.

Technical analysis is built upon the following premises:
    1. Market action discounts everything
      • cornerstone of technical analysis
      • anything that can possibly affect the price (fundamentals, politics, psychology, etc) is actually reflected in the price of that market
    2. Prices move in trends
      • a trend in motion is more likely to continue than to reverse, i.e., a trend in motion will continue in the same direction until it reverses - basic Newton law of motion
    3. History repeats itself
      • patterns have been identified to repeat in charts because they are shaped by human emotions and psychology, which tends not to change
  • If the fundamentals are reflected in market price, then the study of those fundamentals becomes unnecessary.  
  • Technical analysis can be applied to virtually any market and time dimension
  • Technical analysis can be used for economic forecasting - stock markets lead the economy

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