Personal Investor: Unraveling technical analysis
To the untrained eye, technical analysis could seem like a series of charts with nonsensical lines and cryptic symbols. To technical analysts, it’s a glimpse into the future.
Simply put, it’s a statistical method of identifying trends based on the assumption that most human activity is predictable and the past will likely be repeated. Technical analysts evaluate securities through statistics generated mostly by market prices and volume over different periods of time.
They can be found wherever securities are traded and their roots can be traced back to 18th century Japan where Honma, the god of the markets (and a successful rice trader), is believed to have invented the craft. More recently, Charles Dow, co-founder of the Dow Jones Industrial Average, put the wheels in motion for technical analysis through his Dow Theory at the end of the 19th century.
There are several different technical methods and tools to predict market trends, thanks in part to the increasing popularity of computer-assisted techniques. One popular example is the moving average, which tracks the average price of a security over a specified period of time. The moving average is used to spot trends by flattening out large fluctuations.
Unlike fundamental analysts, technical analysts do not attempt to quantify a security's intrinsic value. A fundamental analyst studies the actual nature of a security, while a technical analyst is not concerned with such fundamentals as corporate profits, supply and demand or quality of management. The technical analyst believes that sort of information is already priced into the market.
To get a better idea of how technical and fundamental analysts differ, imagine the two on a shopping trip. The fundamental analyst will study a product and determine its value through such measures as price-to-book or price-to-earnings ratios. If the stock is trading lower than his defined value, he buys it. The technical analyst, on the other hand, will wait outside the store and study what items are being purchased by other shoppers. He will assume those shoppers have reasonably valued the bought items, so they must be fairly priced.
Technical analysis, of course, is not completely accurate, but several studies have shown it to be correct more often than not.