Technical Analysis in Financial Markets - Literature review Example

Technical analysis in financial markets Technical analysis is the use of earlier information on price and volume to anticipate or forecast their future values. In the words of Stevens (2002, p. 4), "it is the study of any market that uses price and volume information only to forecast future prices movements and trends." Technical analysis is one of the most useful techniques in the study of financial markets prior to making buying or selling decisions. Stevens (2002, p. 4) also pointed out that "technical analysis and technically oriented investors or traders rely on historical and current price and volume information only." Yet, at the same time, Stevens clarified that other related information is considered part of technical analysis, particularly sentiments such as bullishness, bearishness, or neutrality in the market (p 4, second and third paragraphs). Stevens called this as the third element in technical analysis, with price and volume as the first and second elements (p. 4). Meanwhile, an alternative for analyzing financial markets is fundamental analysis that concentrates "solely" on the study of fundamental market factors, relying instead on an analysis of the supply and demand conditions of a market (Stevens, 2002, p. 5). The market conditions are believed to be ultimately reflected in earnings relative to being a multiple of chosen market indices. For example, a fundamental analyst may try to assess whether a stock or a financial asset has a price that represents a certain multiple of a past or projected annual or periodic earnings known as P/E or price-earning ratios. The ratios are then assessed whether they are within, above, or below market averages and then assessed if the values are warranted based on market conditions where market sentiments also come into play (Stevens, 2002, p. 5). Mendelsohn (2000, p. 36) pointed out that although fundamental and technical analyses have their own philosophical foundations and look at markets from two distinct standpoints, the methodologies have a common goal which is to "identify and forecast the market trend direction." Mendelsohn emphasized that technical analysis is an analytic process that involves technical studies, market data, and study of patterns where the main goal is to identify current trend, forecast future trend, and estimate price targets (2000, p. 36). The rationale for technical analysis consists of the following (Stevens, 2000, p.6): 1. Market is efficient and will accurately reflect correct market values over time. 2. Full information on company stock or asset values compared with earning power will be ultimately reflected in market prices and, in turn, the information will be reflected in the price or volume trends, especially long-run trends. 3. Price reoccurrence is also important information because reoccurrence can indicate that the same pattern will again re-emerge and, if not, will be indicative of important changes in market conditions. An alternative for the describing the three points above is to call them as assumption of technical analysis. This indicates that technical analysis will be useful so long as the three points above apply. There are important criticisms on technical analysis. Based on Stevens (2002, p 7-8), these are as follows: 1. Proof is unavailable whether technical analysis really works. A large part of technical analysis is an analysis of trends and there may be no adequate foundation in theory why prices and volumes have to follow a trend. 2. In some instances, technical analysis may appear to work because sentiments driven by technical analyses can affect market prices. A belief that prices will fall can lead to falling prices even if supply and market conditions are unchanged. However, there can be changes or demand and supply curves shifts as consumers and producers adopt the sentiments of analysts as their own. 3. Price and volume movements may be random and do not follow a trend. Despite perceived limitations, technical analysis remains extremely useful for analyzing financial markets because a large part of market variable values can be following a trend, whether that trend resulted from a policy event, changes in market conditions, or something that is consistent with consumer or producer sentiments in the market. Neely (1997, p. 23) confirmed that technical analysis is useful for the exchange rate and other markets as well. Neely, Weller, & Dittmar (1997, p. 1-4) even asserted that using technical analysis is profitable in the foreign exchange market. Allen (2003, p. 1) discovered that technical analysis is not only useful for short-term or speculative investors but also for long-term investors as well. Zhu & Zhou (2007, p. 1-2) confirms that when stock returns are predictable, technical analysis adds value to prediction and can therefore complement the predictions of finance theory. Zontos, Christos, & Valvis (2009, p. 1-2) also find technical analysis useful for profitably managing mutual funds. Background Intelligence.com (2005, p. 2-3) provided a background on the emergence of technical analysis. According to the company: The origin of technical analysis can be attributed to Charles Dow who also invented the fist stock market index (1884). Dow invented point and figure charting based on responses of prices and volumes to news and decided to plot these in graphs. Based on his studies, Dow wrote a series of articles for the Wall Street Journal in the late 19th century and the writings became known as the "Dow Theory" that constitutes the beginnings of technical analysis. In his articulation, Dow pointed out that the "hopes and fears" of investors are ultimately reflect in supply and demand conditions (Intelligence.com, 2005, p. 2). Tools for technical analysis Technical analysis use graphical patterns in assessing trends in price and volume prices. The chart type that is more consistent to historical or past data on prices and volume of a financial asset are used to project, forecast, or anticipate the future values of prices and volumes. Some of the most important chart types are as follows (Investor.com, 2005, p. 3-6): 1. Line charts. This chart uses a line to connect price or volume values and can be useful for transforming price or volume values into indicators that have only one value during a day. 2. Bar charts. Bar charts may be useful to chart the lowest value of the price or volume during a day in which the bottom of the bar represents the lowest price while the top of the bar is used to reflect the highest value of the price or volume. 3. Candlestick charts. This chart is more detailed than the bar chart because "up days" or the days wherein the price or volume values increased are represented by un-shaded bars while "down days" or where price or volume values decreased are represented by shaded bars. In addition, the box itself represents the open as well as opening values while the wick represents the range of values of the price or volume for the whole day. 4. Point and figure charts. This chart registers significant price movements as they occur, "eliminating minor movements so that the primary trend" is the one that is only reflected without the "noise" or insignificant movements. Point and figure charts are useful because they reveal the trend that is developing and eliminate those that are only erratic or "noise." In addition to the four basic types of charts, technical analysts consider certain concepts as extremely useful for technical analysis (Investor.com, 2005, p. 6-14): 1. Support and resistance. Support is the price or volume level in which buying is strong enough while resistance is the level in which selling outweighs the tendency to buy. 2. Condition for new level of support. When market conditions improved and resistance is crossed, market price and volume movements can indicate a new level of support and prices may or may not immediately reveal a new level of resistance. 3. Uptrend. For a volume or price variable to be on an uptrend, there must be successive higher peaks or highs simultaneous with successive higher troughs or lows. 4. Downtrend. For a volume or price variable to be on a downtrend, there must successive lower peaks or "highs" simultaneous with successive lower troughs or lows. 5. Overcoming a double bottom. When resistance of two successive bottoms is crossed, technical analysts can interpret the situation as positive especially when a new volume or price support level emerges. 6. Triple or more bottoms on a clear volume or support level. When there are three or more bottoms at a specific price level then that bottom can be interpreted as a strong support level. 7. Double top. The inverse of a double bottom is the double top that can indicate a strong resistance especially when a triple or more tops emerge. 8. Heads and shoulder formation. This is different from the double top because a heads and shoulders formation involves a lower second top, indicating a decreasing demand for the asset. 9. Neckline. The line connecting the bottoms is the neckline of a trend. 10. Moving average. The movement of an average value, the price or volume average of several days of trading for example, is used as an indicator to identify areas of support or resistance, major trends, and as a supplementary indicator for technical analysis. The moving average can be mathematical or usual or can be in a more complicated formula that assigns weighs to current or more recent prices. 11. Relative strength index (RSI). This measures the strength of a financial asset relative to historical data or values in the past. It measures the average price gains over the average price losses within a given period. An increasing RSI indicates that holding the asset is favored while a decreasing value indicates the reverse. Conclusion In summary, despite limitations, technical analysis is a useful technique for anticipating and projecting price and volume values for financial assets. It can assist market players whether to hold on, buy, and sell assets that can be helpful in promoting affluence and prosperity. Technical analysis can also be used as an indicator of the economys health based on price and resistance levels of markets. In addition, to the extent that the price or volume trends reflect market expectations, they reflect the sentiments of players in the market that can be the basis for government, trader, or asset holder action. Reference List Allen, W. C. (2003). Technical analysis for long-term investors. Retrieved 11 December 2009 (68 pages), from http://www.clayallen.com/TALTI.pdf Intelligence.com. (2005). Investor intelligence introduction to technical analysis. Retrieved 11 December 2009, http://www.investorsintelligence.com/img/help/ii_technical_analysis.pdf Mendelsohn, L. B. (2000). Trend forecasting with technical analysis. United States of America: Marketplace Books. Neely, C. J. (1997, September/October).Technical analysis in the foreign exchange market: A laymans guide. Review (September/October), 23-38. St. Louis: Federal Reserve Bank of St. Louis. Neely, C. J., Weller, P., & Dittmar, R. (1997). Is technical analysis in the foreign exchange market profitable? Journal of Financial and Quantitative Analysis (December), 1-42. Skiena, S. (2009). What is technical analysis? Retrieved 11 December 2009, from http://www.cs.sunysb.edu/~skiena/691/lectures/lecture11.pdf Stevens, L. (2002). Essential technical analysis: Tools and techniques to spot market trends. New York: John Wiley & Sons, Inc. Zhu, Y. & Zhou, G. (2007). Technical analysis and theory of finance. Retrieved 11 December 2009, from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=968216 Zontos, S., Christos, S., & Valvis, Y. (2009). Technical analysis and mutual funds: Testing trading rules. Retrieved 11 December 2009, from http://www.erudit.de/erudit/events/esit99/12606_p.pdf Read More