Technical analysis

 What is technical analysis?

Technical analysis is a concept that can be used to analyses the price movements of financial instruments with the objective of identifying profit opportunities. The benefits of technical analysis have been often discussed but it is also important to look at the criticism of this concept at this point to understand all the implications. Scientists, and especially the proponents of the efficient market hypothesis, compare technical analysis with pure speculation, whereby a reference to the popular dart throwing monkey experiment is often made. On the other hand, a report by Neely and Weller confirms that technical analysis might be superior to fundamental data analysis in the short-term investment horizon. Y. Zhu and G. Zhou recognizes that the momentum effect can be a potentially profitable technical strategy based on historical price patterns. A study of over 2,000 Chinese stocks confirmed that the effectiveness of the analysis could be significantly improved with the support of technical tools. Another study of the Russian stock market suggests that trading systems that use technical indicators might outperform a simple “buy-and-hold” strategy.

Technical analysis and crowd psychology

Prices on the financial markets move, among other things, because millions of people and institutions interact on the international financial markets every day. Financial market players make buying and selling decisions that influence the pricing of financial instruments and cause upward and downward prices fluctuations. Technical analysis is so effective because people always follow the same behavioral patterns and often make their trading decisions collectively based on similar emotions.

Most people will already know sayings like “greed is good” or “shares are bought based on expectations and not based on facts”. This indicates that the human psyche and general thinking patterns are an important part of developments on the financial markets. Whether we are looking at a speculator from China 200 years ago, a Wall Street pit trader from New York 80 years ago or a modern-day "Joe Bloggs Trader" – the human components, i.e. emotions and instincts hardly differ. Greed, fear, uncertainty and the willingness to take risks have determined human actions for millennia and, of course, how people have maneuvered their money around the world's markets for centuries. When we learn to read the buyer and seller interaction from the charts, we will be able to read and handle any price chart, on any market and for all times going forward.

Another important reason why technical analysis is so effective is because of the principle of the self-fulfilling prophecy. Since millions of people follow the concepts of technical analysis and make decisions based on them, they verify the fact that technical indicators and other concepts work simply because they are widespread. Even the financial media often refer to technical concepts such as past highs and lows, all-time highs and lows, psychologically important price levels and moving averages.

When we delve into the analysis of pricing structures and chart studies during this book, you will soon realize that technical trading is much more than it seems at first glance. We will develop an understanding that will enable us to put ourselves in the shoes of other traders and interpret the thought processes of financial market players, so that we can ultimately benefit from technical analysis through independent strategic thinking.

Most traders carry out technical analysis only at an extremely superficial level since the majority of the literature does not usually deal with the underlying mechanisms in-depth. Here, the criticism by the opponents of technical analysis would even be justified, because such an approach is not effective and trading cannot be reduced to surface level thinking. This book has the goal to explore technical analysis in a new and more effective way.