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Friday, November 9, 2007

Technical Analysis – Definition & Assumptions

Many investors / traders use Technical Analysis to help them in their entry & exit strategies. Ideally, Technical Analysis should be used hand in hand with Fundamental Analysis, as the two methods have their own pros & cons.
However, some people argue that for short term trading (e.g. day trading, 1 – 5 days swing trading), Fundamental Analysis may not be as critical as that for longer term trading / investing.

The following would discuss further what Technical Analysis is and its basic assumptions.

What Is Technical Analysis?
Technical Analysis
is a method used to attempt to predict future stock prices based on historical prices and stock chart patterns / trends.
Technical analysis uses no information about the actual business or financial performance of the underlying company.
Technical analysis can be applied to an individual stock as well as market as a whole.

In contrast, Fundamental Analysis attempts to make investment decision based on the evaluation on the company's business & operation, overall financial health / condition, management quality, marketing aspects, future outlook of the company, industry factors, as well as economic and political conditions.
The Fundamental analysis will then compare the valuation with the prevailing market price to ascertain whether the stock is overpriced, underpriced, or priced in proportion to its market value.

The Basic Assumptions of Technical Analysis
* A stock price has factored in all known information (e.g. the stock’ fundamental / intrinsic values, events, economic outlook and market psychology, etc.) about a stock.
As such, there is no need to study each factor individually, but instead just need to focus on the price behaviors only.
* Disregarding minor fluctuation, prices tend to move in trends.
However, prices do not move in a trend forever. When prices change direction, the move normally does not occur directly & obviously. Prices tend to move sideways first, fluctuating up and down, as investors try to analyze the market and arrive at a conclusion about where they think the stock price should be heading based on their new price expectations for the stock. These sideways movements cause price patterns to form on the chart.
* History will repeat itself, over and over again.
The price patterns tend to repeat, offering investors a prediction of where prices may be heading.This is possible because human behavior will never change. The repetitive & predictable human behavior, psychology and reactions towards various supply vs. demand forces are the foundation of technical analysis.

History repeats itself in the stock market. Many price patterns and price consolidation structures that stocks form are repeated over and over again.

William J. O'Neil

As Technical Analysis mainly uses charts patterns to predict future stock price behavior, it is commonly called as “Charting”.

In the next posts, we’ll discuss about chart patterns.
In the meantime, have a good weekend ahead. :)

Related Posts:
* Learning Charts Patterns
* Learning Candlestick Charts
* Options Trading Basic – Part 2
* Understanding Implied Volatility (IV)
* Option Greeks