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Technical analysis is the practice of developing rules to trade securities based on the past price movements of the securities markets and individual securities. The definition can be extended to include trading rules that results in behaviourial factors, such as Contrarian investing.
It doesn't work very well in an efficient market. Efficiency can reasonably be defined as the extent to which this sort of thing doesn't work.
Why people are using it
There are several factors which encourage widespread use by people, especially stupid businesspeople:
- No information on Sales, cash flow, earnings, customer base and other information are needed.
- Major financial reporting standards (like IFRS and US GAAP) have procedural variations such that the numbers such as income, expenses, return on assets etc. may vary drastically due to different practices. Technical analysis does not require adjustments to the financial statements in order to make firms comparable.
- Psychological factors and other nonquantifiable factors often affect the prices of the security and do not usually appear on the financial statements. example include employee training and loyalty, customer goodwill, and general investor attitude.
These factors are related to the fact that since one does not need financial statements for technical analysis, it saves time and brain power to process the information.
Why this usually does not work
The efficient market hypothesis, even in the weakest form, argues that the prices of securities reflect all market information, including but not limited to rates of return, sequence of prices, trading volume and any information that can be generated by market data. In simpler terms, future rates of return is statistically independent of the past rate of return. As a result, the hypothesis contends that trading rules derived from market data will not systematically get superior gains. This form of the hypothesis is usually well-supported by statistical tests of securities on the NYSE and NASDAQ.
To be fair, this works up to the point...
Don't expect it to work in any major stock exchanges, however.
- See the Wikipedia article on Efficient market hypothesis.
- See the Wikipedia article on Technical analysis.
- See the Wikipedia article on Arbitrage.
- Source of most of the information comes from CFA Curriculum, Level 1, 2008
- See the Wikipedia article on Contrarian investing.
- The analysis that requires financial statement is called fundamental analysis
- Compared to, for example, buy and hold.
- As in prices do not update very often, like computers are not even available in the stock exchange due to technology (For example, if you are living in the 1810s) or cost limitations (Given the fact that listing on a stock exchange requires fees paid to the stock exchange, this is mostly a non-issue).
- It is also possible to exploit prices movements created by technological limitations in terms of bandwidth limits of data (before networking is invented, perhaps) because different stock exchanges may have different prices for the same securities. However that's beyond the scope of technical analysis.
- In the strictest sense, it refers to any profit requiring zero risk and zero investment. For the purpose of this article, a more popular interpretation is used -- the superior risk-return trade-off which may or may not require risk and/or investment.