The market action sums up all needs, wants and expectations of all participants and as such delivers key information regarding probable future trends.
Technical analysis - or behavioral finance - is the process of analyzing historical market action, primarily through the use of charts, in an attempt to determine the most probable direction of future price trends.
There is a distinction between market action and price action. While the terms are sometimes used interchangeably, market action encompasses all primary sources of information available to a technical analyst: price, volume, time, and, open interest, if applicable.
Fundamental analysis requires that investment and trading opportunity is understood by analyzing macro- and micro-economic fundamentals. While fundamental analysis is a big part of the decision-making process, we believe that a fundamentals-only approach is limited and incomplete. Markets oftentimes remain irrational much longer than traders can stay solvent and sometimes even do the very opposite of what the fundamentals would otherwise suggest they should be doing. Consequently, it is necessary to fine-tune the timing of all and any investment and trading decisions.
We believe that the connection between market fundamentals and market action is profound. We disagree, however, with the projected consistency of perfect correlations between fundamentals and price action. We also reject linear extrapolations of the recent past into the indefinite future as a useful way to approach markets. Much like markets themselves oscillate up and down, so does the importance of specific fundamental variables – and we contend correlations are generally time and/or context-dependent. This is in part because changes in fundamental variables produce non-linear impacts in asset valuations and thus lead to non-linear market outcomes.
Our forecasting model reconciles market technicals with market fundamentals at various points in the economic cycle. The method we use balances the true nature of economic fundamentals with the perceptions towards them, revealing the background and tangible manifestation of mass psychological trends that we contend drive both the markets and the economy.
Technical analysis is based on three assumptions:
Technicians believe that all known market influences are fully discounted in prices. In other words, there is little edge to be gained by performing further fundamental analysis. All that is required to forecast the prices is a study of prices themselves.
An equally important premise is that prices of financial assets move in trends which tend to persist for a while. The trend-following approach is in fact the very essence of the technical analysis: technical analysis is about identifying trends of various sizes in their earliest possible stages of development and riding them until they are about to reverse.
The market action is obviously subject to infinite variability and no two situations are identical, yet some may bear some similarities with others. Technicians believe that, since mass psychology never changes at its core over the course of time, situations revealing similar emotional setups end-up generating price patterns of similar, repetitive form that have predictive value.
Understanding the rationale of technical analysis is the first step in understanding the benefits of charting. In simple terms, technical analysis provides superior flexibility, improves your market timing, and removes a significant amount of subjectivity from your investment decisions.
One major benefit of charting is that the same set of rules and guidelines can be applied to study any market in any time frame. Whether the analyst is inspecting a USDollar index quarterly chart or a five minute E-mini S&P 500 chart, they will utilize the same principles. By contrast, fundamental analysts typically employ different methodologies and analyze separate types of data sets to arrive at forecasts in different asset classes. The convenience of analyzing the same type of data by the same type of guidelines implies that technicians, as opposed to fundamental analysts, can quickly move from one market to the other and profit from the most attractive market swings within the entire financial spectrum, regardless of their investing time horizon.
Even if one uses fundamental analysis to determine what to buy or what to sell, the timing aspect of his investment decision remains unresolved. Experienced professionals will often tell you that it is less relevant what you buy or sell but it is crucial when you do it. Technical analysis will help you objectively determine entry, stop-loss and profit-taking levels so that risk is properly contained while opportunities are thoroughly enjoyed.
Technical analysis will help you remove the natural temptation to follow the herd while you trade. It will help you objectively assess the underlying psychological environment and decide how you should act given the overall circumstances.
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