Top Tools for Successful Technical Analysis: Introduction

While there are many different approaches to the analyzing of the markets, technical analysis initially appears to be the easiest but may prove to be the most difficult to successfully implement.

Technical Analysis is usually defined as the study of the action of the market itself. It looks at prices and volume on a historical basis in an attempt to forecast the probable future trend of prices. Technical analysts use charts and a variety of mathematical indicators based upon price or volume to help them assess the market.

There are three underlying assumptions to the study of technical analysis:

1) Market action discounts the future. Discounting the future is an accounting concept that means investors value stocks, or anything else they are trading, based upon what is going to happen in the future, not what has happened in the past. So if we see the stock of XYZ declining, investors are saying that the company will make less money in the future than they have in the past.

This assumption refers to market action because the principles of technical analysis apply to anything that is freely traded. Common examples are stocks, bonds, commodities, or foreign exchange. However, the principles also apply to houses and anything else that can be bought or sold.

2) Prices move in trends. This is because not all investors will agree on the future prospects of a particular stock or commodity. Some may think that Car Company XYZ will be able to sell more cars because they believe the economy will improve. Others think they will sell more cars because consumers will want to replace their gas guzzling SUVs with more fuel-efficient vehicles. Some may think XYZ will sell fewer cars because consumers prefer cars made by Company ABC. The price of XYZ stock will move higher and lower as different investors act on their ideas. Usually the majority opinion is right over the longer term and as investors recognize the facts about the underlying stock, they buy or sell based upon their changing beliefs. That is why trends exist - all investors eventually are forced to act on the reality of the underlying business.

3) Technical analysts assume that history repeats itself. This applies to many areas of human behavior. The markets are simply a reflection of human behavior. They are measuring what happens when millions of investors with different opinions get together to act on their ideas. Emotion is an integral part of many decisions, and we certainly saw a lot of greed in early 2000 as internet stocks soared to incredible heights. Fear took over and drove the prices of almost all stocks to incredible lows over the next two years. The same thing happened with tulips in the Netherlands in the seventeenth century. At one point in time, tulips cost ten times what the average worker made per year; it was the first speculative bubble. Human emotions always take markets to extremes and have been unchanged over hundreds of years as history has repeated itself over and over again.