Technical Analysis

Assumptions

Technical analysis is also widely used and is the most common tool used by private traders. The use of technical analysis and its effectiveness is based on a number of assumptions about the way the market operates. They are:

  • the market price discounts everything that drives buyers and sellers
  • human nature is constant, resulting in recurring behaviours in response to similar situations and thus generating repetition of certain price patterns
  • prices are not entirely random and move in trends for significant periods of time

Often market participants are driven in their decision making by the information that is available to them, whether the information is publicly available or not.

Technical analysis assumes that all the factors that influence the price of a security have already been factored into the price. This is why technical analysts never concern themselves with why prices go up or down, and one of the reasons why often the price will be a leading indicator of published information.

Despite the passage of time, human nature and behaviour over the years, remains constant. All market participants are driven by similar emotions and will often react to situations in the same way. Moreover, there are always a continual flow of new participants into the market and they are generally ignorant of the way the market has behaved in the past.

For this reason, the same mistakes are often repeated by each new group of market participants.

Technical analysts develop an understanding of the way crowds of people will react to certain situations, and are able to identify certain patterns in price charts. Therefore, they are able to form a view on the likely direction of the price of a security.

If prices did not move in trends, then there would be little use for technical analysis. The more efficient a market is, the less effective technical analysis is, as prices will be random and not move in trends.

Markets are generally efficient, however often the information dispersion takes some time and therefore people react to that information over time increasing the chances of prices trending. Should the information be acted upon immediately, prices will be more random and technical analysis will almost be useless. This is rarely the case, however.