Technical analysis refers to the art of interpreting a chart and has a long history in the financial markets. Evidence points to the Japanese using candlesticks techniques to account for the rise and fall of rice futures in the 1700s. To this day, Japanese candlestick techniques are an essential part of technical analysis. The Western world developed its own approach based on the United States stock market in the late 1800s and early 1900s.
While some markets disappeared (most U.S. companies active in those days no longer exist) and new markets were born (e.g. Forex, derivatives), technical analysis survived the test of time. Not only did it survive, but the personal computer (PC) made it possible to extend the technical analysis to new areas. Nowadays, with a few clicks, one can upload over a decade of historical data, apply indicators, or use technical theories.
The aim is to forecast future prices. Because trading is akin to speculation, investors use technical analysis to find the best probable course of action.
Technical Analysis in the 21st-Century
Technical analysis as we know it today is a mix between new approaches and old approaches that have been adapted to the new market reality.
Technical analysis is comprised of the following categories:
- Trend indicators. These technical indicators follow the price action closely and appear on the main chart. Investors use them to understand the sentiment of the underlying trend. Most representative indicators: Moving Averages, Bollinger Bands.
- Oscillators. Based on sophisticated mathematical formulas, oscillators appear in a separate window at the bottom of a chart. Investors compare the moves the price makes with the ones made by the oscillator and interpret the differences between the two. Most representatives oscillators: Relative Strength Index (RSI), the Moving Average Convergence Divergence (MACD), Stochastics, etc.
- Pattern recognition. Belonging to the Western approach to technical analysis, pattern recognition uses a set of documented “prints” or “footsteps” that appear on a chart. Most representative patterns: head and shoulders, wedges, pennants, bullish and bearish flags, double or triple tops and bottoms, rounding tops and bottoms, etc.
- Japanese candlesticks. As we already mentioned Japanese candlesticks are an essential part of technical analysis. Most representative patterns: the hammer, bullish and bearish engulfing, Doji, morning and evening stars, etc.
- Trading theories. This area comprises all the struggles in the history of technical analysis. Mostly developed in the early 1900’s, these theories still have many uses in today’s financial markets and are very popular. Most representative theories: Elliott Waves Theory, Pitchfork, Gann, Gartley, Harmonics, Dow, Drummond, Point and Figure, etc.
We can safely say that technical analysis is the umbrella term for all technical elements used to forecast markets. Be it candlestick reversal patterns (e.g. hammer) or a sophisticated trading theory aimed at mapping market behavior (e.g. Elliott Waves Theory), technical analysis will continue to fascinate investors as the one way – besides fundamental analysis – to beat the market.
- Technical analysis uses past data to project future price levels.
- Different investors use different technical tools, depending on their style and strategy.
- Technical analysis is as old as the financial markets.
- The Western and Japanese approaches complement each other.
- The personal computer altered technical analysis.