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A Primer on
Technical Analysis
I. Technical Analysis vs.
Fundamental Analysis?
The study of the stock market has
become divided into two schools of thought: fundamental analysis; and,
technical analysis.
Fundamental analysis focuses on the
economic forces of supply and demand that cause prices to move higher,
lower or stay the same. The fundamental approach examines all the
relevant factors affecting the price of a market in order to determine
the intrinsic value of that market. The intrinsic value is what
fundamentalists indicate something is actually worth based on the law of
supply and demand. If this intrinsic value is under the current market
price, then the market is overpriced and should be sold. If market price
is below the intrinsic value, then the market is undervalued and should
be bought.
On the other hand, Technical Analysis
is the study of market action, primarily through the use of charts, for
the purpose of forecasting future price trends. The term "market
action" includes the two principal sources of information available
to the technician - price and volume.
There are three premises on which the
technical approach is based:
1. Market action discounts everything
- The technician believes that anything that can possibly affect the
price - fundamentally, politically, psychologically, or otherwise - is
already reflected in the price of that market. It follows, therefore,
that a study of price action is all that is required.
2. Prices move in trends - The whole
purpose of charting the price action of a market is to identify trends
in early stages of their development for the purpose of trading in the
direction of those trends.
3. History repeats itself - The key
to understanding the future lies in a study of the past, or that the
future is just a repetition of the past. Patterns in the market are
based on human psychology, which tends not to change.
Both of these approaches to market
forecasting attempt to solve the same problem, that is, to determine the
direction prices are likely to move. They just approach the problem from
different directions. The fundamentalist studies the cause of market
movement, while the technician studies the effect. The problem is that
the charts and fundamentalists are often in conflict with each other.
Usually at the beginning of important market moves, the fundamentals do
not explain or support what the market seems to be doing. It is at these
critical times in the trend that these two approaches seem to differ the
most. Usually they come back in sync at some point, but often too late
for the trader to act. One explanation for these seeming discrepancies
is that market price tends to lead the known fundamentals. While the
know fundamentals have already been discounted and are already "in
the market", prices are now reacting to the unknown fundamentals.
Some of the most dramatic bull and bear markets in history have begun
with little or no perceived change in the fundamentals. By the time
those changes became known, the new trend was well underway.
In accepting the premises of
technical analysis, one can see why technicians believe their approach
is superior to the fundamentalists. If a trader had to choose only one of
the two approaches to use, the choice would logically have to be the
technical. Because, by definition, the technical approach includes the
fundamental. If the fundamentals are reflected in market price, then the
study of fundamentals becomes unnecessary. Chart reading becomes a
shortcut form of fundamental analysis. The reverse, however, is not
true. Fundamental analysis does not include a study of price action. It
is possible to trade financial market using just the technical approach.
It is doubtful that anyone could trade off the fundamentals alone with
no consideration of the technical side of the market.
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