10.2 What is the rational behind technical analysis?

Technical analysis

Technical analysts believe that it is possible to forecast the future price of a share by looking at the past price movement. Their main assumptions are:

• The market price of a security is determined solely by supply and demand. Any shift in the supply-demand relationship can be detected sooner or later in the action of the market.

• Supply and demand are governed by numerous factors, both rational and irrational, which include factors relied upon by fundamentalists, as well as opinions, moods, guesses and blind necessities. The market weighs these factors continually and automatically.

• Disregarding minor price fluctuations, stock prices tend to move in trends that persist for an appreciable length of time. Some chart patterns tend to recur and their recurring prices can be used to forecast the price movement. In a nutshell, technical analysts believes in the maxim that ‘history repeats itself’ without giving an in-depth explanation.

How Is Technical Analysis Done?

Ironically, there is no standard procedure followed by all technical analysts. Basically, they follow the Dow Theory and a number of empirical rules developed by chartists for interpreting market movement. Many analysts use the Moving Average Methods in addition to the Dow Theory for predicting price trends. Other popular methods of doing technical analysis are mentioned in this chapter and these include:

1. Price versus volume change
2. The advance-decline line
3. The rate of change (ROC) analysis
4. New-High and New-Low indicators
5. Trending
6. Channels
7. Patterns
8. Moving Average Convergence/Divergence (MACD)