Finance

The Philosophy of Technical Analysis

The first topic I want to learn about is stock investments. Why? Because

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I wish I could say I remember everything from the finance class I took in college (sorry Dad), but I don’t. And I probably should start with a basic refresh course…but I have this pretty hefty book that’s been sitting on my shelf, taunting me for a year now. I just want to get started rather than continuing to worry about the proper way learning it. So…

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What is Technical Analysis?

Techincal analysis is the study of market action, primarily through the use of charts, for the purpose of forecasting future price trends. 

D: Okay cool. What is market action again?

Market Action has 3 sources of information available for us to utilize.

  1. Price
  2. Volume
  3. Open Interest (used only in futures and options).

D-: I guess “price action” and “market action” are used interchangeably.

Philosophy of Technical Analysis

Before getting into the nitty gritty, it’s important to know the 3 premises technical analysis operates on.

  1. Market action discounts everything.
  2. Prices move in trends.
  3. History repeats itself.

D: Okay. I definitely recognize these words…and I definitely know what #3 means. But I really have no idea what this actually means. 

Let’s break it down.

Market Action Discounts Everything

Apparently, this is the holy grail of technical analysis. So this is kind of a big deal.

“The technician believes that anything that can possibly affect the price – fundamentally, politically, psychologically, or otherwise – is actually reflected in the price of that market. It follows, therefore, that a study of price action is all that is required. While this claim may seem presumptuous, it is hard to disagree with if one takes the time to consider its true meaning.” -John Murphy

D: That is pretty presumptuous John. I thought I was supposed to be glued to my phone, watching the markets, analyzing the company’s fundamental business structure and following what that company is doing every single second like a complete stalker. What are you telling me?

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All John is saying is that Price Action (reminder: price, volume and open interest) should reflect shifts in supply and demand.

  • Demand > supply->Prices should rise. Bullish.
  • Supply > demand-> Prices should fall. Bearish.

So a technician works backward and concludes:

  • If the prices are rising (who knows why specifically…and John really doesn’t care), demands must be exceeding supply. Thus, the fundamentals are bullish. 
  • If the prices are falling, the fundamentals must be bearish.

D: Side bar. Bullish. Bearish. What do those terms mean?

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  • Bullish Market: When investors think stock prices will increase over time.
  • Bearish Market: When investors think stock prices will decrease over time. 
  • Fearless Girl: Every girl’s hopes and ambitions. 

John at the end of the day only cares about fundamentals. The fundamentals of supply and demand cause bull and bear markets. All charts created only reflect the bullish or bearish psychology of the marketplace. He doesn’t concern himself as to why prices rise or fall. If everything that affects market price is ultimately reflected in market price, then the study of the market price is all that is needed. So all a technician really does is look at the points on the price chart and lets the market say which way it most likely will go. Sure there are reasons why the markets are going up and down. But she doesn’t believe it’s necessary knowing those reasons in the forecasting process. 

Prices Move in Trends

Trends are pretty essential to technical analysis. If you can’t accept that markets trend, then this approach probably isn’t for you. 

D: Okay…this makes me feel better that I’m not just gambling away my measly amount of money. There may be some logic to it. 

The whole purpose of charting price actions of a market is to help identify trends in the early stages of their development for the purpose of trading in the direction of those trends.

“A trend in motion is more likely to continue than to reverse.” -John’s adaptation of Newton’s First Law of Motion

Another way he looks at this is that a trend in motion will continue in the same direction until it reverses. 

D: Mhmm. Those last 3 words are concerning.

The entire trend-following approach is predicated on riding an existing trend until it shows signs of reversing.

D: Fine. Ride the wave as much as possible and when you start seeing that it’s reversing…ride that wave. 

History Repeats Itself

Much of the body of technical analysis and the study of market action has to do with the study of human psychology. Chart patterns tell a story of the bullish or bearish psychology of the market. Since those patterns have worked well in the past, it is assumed they will work well in the future. Human psychology doesn’t tend to change. History is doomed to repeat itself. 

 

That’s all for now.

If you want to do your own reading, all of this is coming from John Murphy’s “Technical Analysis of the Financial Markets: A Comprehensive Guide to Trading Methods and Applications”.

And here is a picture of John looking so cute. 

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-D

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2 thoughts on “The Philosophy of Technical Analysis

  1. 1. could you clarify the nature of futures and options in regards to open interest?
    2. What are signs of a reversing trend?
    3. How can John only be concerned with market price, but then turn around and look at human psychology? Sounds like he is speaking out of both sides of his mouth. Maybe not.

    Like

    • Hi Luke,

      I wish I knew the answers to your first two questions. I have a pretty good feeling that I’ll be learning the answers soon enough. I’ll be learning about charting techniques at some point and I believe that’s where we’ll begin to identify signs of reversing trends.

      For your third question, I think what John is saying is that human psychology does not really fluctuate. It is a constant for him. And the market price, as it is, encapsulates everything (supply vs. demand, the bullish or bearish sentiment of the market/people, etc.) So from there, he can look at the current chart pattern, probably compare it to similar historical charts, and forecast that human behavior/market moving forward.

      That’s just my wild guess but we’ll see 🙂

      -D

      Like

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