INTRODUCTION - Technical Analysis
Should I buy today? What will prices be tomorrow, next week, or next year? Wouldn't
investing be easy if we knew the answers to these seemingly simple questions? Alas, if you
are reading this book in the hope that technical analysis has the answers to these
questions, I'm afraid I have to disappoint you early--it doesn't. However, if you are
reading this book with the hope that technical analysis will improve your investing, I have
good news--it will!
The term "technical analysis" is a complicated sounding name for a very basic approach to
investing. Simply put, technical analysis is the study of prices, with charts being the
The roots of modern-day technical analysis stem from the Dow Theory, developed around
1900 by Charles Dow. Stemming either directly or indirectly from the Dow Theory, these
roots include such principles as the trending nature of prices, prices discounting all
known information, confirmation and divergence, volume mirroring changes in price, and
support/resistance. And of course, the widely followed Dow Jones Industrial Average is a
direct offspring of the Dow Theory.
Charles Dow's contribution to modern-day technical analysis cannot be understated. His
focus on the basics of security price movement gave rise to a completely new method of
analyzing the markets.
The human element
The price of a security represents a consensus. It is the price at which one person agrees
to buy and another agrees to sell. The price at which an investor is willing to buy or
sell depends primarily on his expectations. If he expects the security's price to rise, he
will buy it; if the investor expects the price to fall, he will sell it. These simple
statements are the cause of a major challenge in forecasting security prices, because they
refer to human expectations. As we all know firsthand, humans are not easily quantifiable
nor predictable. This fact alone will keep any mechanical trading system from working
Because humans are involved, I am sure that much of the world's investment decisions are
based on irrelevant criteria. Our relationships with our family, our neighbors, our
employer, the traffic, our income, and our previous success and failures, all influence our
confidence, expectations, and decisions.
Security prices are determined by money managers and home managers, students and
strikers, doctors and dog catchers, lawyers and landscapers, and the wealthy and the
wanting. This breadth of market participants guarantees an element of unpredictability and
If we were all totally logical and could separate our emotions from our investment
decisions, then, fundamental analysis the determination of price based on
future earnings, would work magnificently. And since we
would all have the same completely logical expectations, prices would only change when
quarterly reports or relevant news was released. Investors would seek "overlooked"
fundamental data in an effort to find undervalued securities.
The hotly debated "efficient market theory" states that
security prices represent everything that is known about the security at a given moment.
This theory concludes that it is impossible to forecast prices, since prices already
reflect everything that is currently known about the security.
The future can be found in the past
If prices are based on investor expectations, then knowing what a security should sell for
(i.e., fundamental analysis) becomes less important than knowing what other investors
expect it to sell for. That's not to say that knowing what a security should sell for
isn't important--it is. But there is usually a fairly strong consensus of a stock's future
earnings that the average investor cannot disprove.
"I believe the future is only the past again, entered through another
---Sir Arthur Wing Pinero, 1893
Technical analysis is the process of analyzing a security's historical prices in an
effort to determine probable future prices. This is done by comparing current price action
(i.e., current expectations) with comparable historical price action to predict a
reasonable outcome. The devout technician might define this process as the fact that
history repeats itself while others would suffice to say that we should learn from the
The roulette wheel
In my experience, only a minority of technicians can consistently and accurately determine
future prices. However, even if you are unable to accurately forecast prices, technical
analysis can be used to consistently reduce your risks and improve your profits.
The best analogy I can find on how technical analysis can improve your investing is a
roulette wheel. I use this analogy with reservation, as gamblers have very little control
when compared to investors (although considering the actions of many investors, gambling
may be a very appropriate analogy).
"There are two times in a man's life when he should not speculate:
when he can't afford it, and when he can."
---Mark Twain, 1897
A casino makes money on a roulette wheel, not by knowing what number will come up next,
but by slightly improving their odds with the addition of a "0" and "00."
Similarly, when an investor purchases a security, he doesn't know that its price will
rise. But if he buys a stock when it is in a rising trend, after a minor sell off, and
when interest rates are falling, he will have improved his odds of making a profit. That's
not gambling--it's intelligence. Yet many investors buy securities without attempting to
control the odds.
Contrary to popular belief, you do not need to know what a security's price will be in
the future to make money. Your goal should simply be to improve the odds of making
profitable trades. Even if your analysis is as simple as determining the long-,
intermediate-, and short-term trends of the security, you will have gained an edge that you
would not have without technical analysis.
Consider the chart of Merck in Figure 1 where the trend is obviously down and there is
no sign of a reversal. While the company may have great earnings prospects and
fundamentals, it just doesn't make sense to buy the security until there is some technical
evidence in the price that this trend is changing.
If we accept the fact that human emotions and expectations play a role in security pricing,
we should also admit that our emotions play a role in our decision making. Many investors
try to remove their emotions from their investing by using computers to make decisions for
them. The concept of a "HAL," the intelligent computer in the movie 2001, is appealing.
Mechanical trading systems can help us remove our emotions from our decisions. Computer
testing is also useful to determine what has happened historically under various conditions
and to help us optimize our trading techniques. Yet since we are analyzing a less than
logical subject (human emotions and expectations), we must be careful that our mechanical
systems don't mislead us into thinking that we are analyzing a logical entity.
That is not to say that computers aren't wonderful technical analysis tools--they are
indispensable. In my totally biased opinion, technical analysis software has done more to
level the playing field for the average investor than any other non-regulatory event. But
as a provider of technical analysis tools, I caution you not to let the software lull you
into believing markets are as logical and predictable as the computer you use to analyze