Technical Analysis

Based primarily on statistical tools, technical analysis forecasts a probable future price activity. By plotting the findings on charts, investors get a better visual comprehension of price volume data. Because of that, technical analysis also is as much of an art form as a science. As an art form, it is an interpretation subjective. However, it is also flexible in its approach and each investor should use only that which suits his or her style. Even though it is a form of art, it uses statistical tools to examine historical price and volumes data, and according to the finding it tries to distinguish which side is prevailing: are the bears smashing down the market, or are the bulls gaining steam for the rally up by scaring away the bears?

From the technician’s perspective, price is a result of battle between the forces of supply and the forces of demand and the goal is to have a probable forecast of price future direction.

At the turn of the last century, Dow Theory laid the foundations for what was later to become a modern technical analysis. The theory’s tenets state that the market has three trends. A major trend may last from less than a year to several years. An intermediate trend can last from ten days to three months and this trend usually is a 30% to 60% retrace from the major trend. The minor movement varies from several hours to a month or so.

The Dow Theory’s Tenets

1. Try to visually realize trends and their sizes.

2. Trends have three stages. Stage one is when investors are actively buying or selling against the prime trend down or up trend. During the process, prices do not change much, just an absorbance or release of markets supply or demand. Stage two is faster than stage one; eventually, market participants spot the absorbance or release, then a rapid price change occurs. This stage continues until market participants begin collecting gains from the last move. Stage three is when the first traders starts distributing their holdings in the market.

3. A stock's price will change in response to any new financial information.

4. Stock market averages must confirm each other. To Dow, in his day, a bull market in the industrials sector could not occur unless the railway average rallied as well. Under the assumption that manufacturers' profits are rising, followed by production expansion, the more production and the increased shipment of goods is definitely a sign of the industrials sector-stemming rally.

5. Trends are confirmed by volume. Dow believed that if many participants are interested in the same financial instrument, this will lead to active trading and a growing trading volume. When the instrument starts to gain or lose then it is, rather, a good sign for a trend.

6. Trends are trends, until definitive signals prove that they have ended. Markets might temporarily change to the opposite direction of the trend, but probably they will soon resume to the main trend.

Technical analysis considers mass psychology as a fundamental key for its ability to analyze and forecast future prices. On the other hand, a fundamental analyst considers being logical and tries to find an educated explanation concerned with why the price is in its current state.

The main and most accepted approach by technicians for analyzing a financial instrument is divided to two categories. First is the top-down approach and the second is the time-frame approach.

The top-down approach starts with a broad market analysis through the global economy. Analysts study commodities prices, cross exchanges and their implications, get a grip on global issues, and then they read analysis on major indices such as the S&P 500, Dow Industrials, NASDAQ and NYSE Composite. Then they delve into sector analysis to identify a sector that is the most influenced, negatively or positively. A sector is group of companies that are participating in the same line of business, such as the pharmaceuticals sector. Companies in that sector are developing, manufacturing, and distributing drugs in the healthcare industry. The health care industry is comprised of several sectors. Today of course, technicians can trade a sector or an industry using ETFs. Then when they have a general idea of what is the main direction (bull, bear, or sideways), then the technicians analyze individual stocks to identify the most influenced stocks within the selected sector. 

When technicians decide to enter a certain trade, they analyze the stock in time frames. Just as the top-down approach delves from the big picture to spot a certain stock and then after they have spotted the stock, the second step is the time frame approach in which three time frames are analyzed. The first time frame is the longest and it shows the major trend. The second time frame shows the current trend, and the third time frame pinpoints an entering point.

For example, Toll Brothers, Inc (TOL) is engaged in designing, building, marketing, and arranging finance for single-family detached and attached homes in luxury residential communities. The company is also involved, directly and through joint ventures, in projects where it is building, or converting existing rental apartment buildings into high-, mid- and low-rise luxury homes.