Why You Should Understand Technical Analysis When Analysing Financial Instruments

Technical analysis has been around for many hundreds of years, dating back to the 18th century when a Japanese rice trader developed candlestick charting.

Just after the turn of the 20th Century, Charles H. Dow’s (as in Dow Jones) contributions greatly increased the discipline’s prominence and his works were then expanded upon most notably by Hamilton (1922) and Rhea (1932), and a host of others thereafter.

Despite the continued development of the theoretical side of the discipline, until quite recently technical analysis remained confined to the realm of large institutions that possessed the necessary money and resources required to utilise it effectively.

Initially the money and resources were used employing research analysts who would construct and maintain hand-drawn charts but this eventually gave way to computers. In the early days, however, computers filled entire rooms and, once again, could only be afforded by large institutions.

It has only been in the last 10-15 years that personal computing power has allowed retail traders/investors the opportunity to utilise technical analysis as a tool for analysing financial instruments which, in all honesty, has proven to be both a good thing and a bad thing.

For an example of how far along we’ve come in this area, one need look no further than the I-phone which already allows traders/investors to access trading platforms and charts in order to place trades at any time, wherever they may be around the world.

Interestingly, technical analysis has also become a significant source of revenue and profit for major financial institutions due to technological advancements, i.e. the Goldman Sachs of this world.

Algorithmic and high frequency trading have developed because computers can read information, interpret it, and execute orders much, much faster than human beings. The clear majority of these systems are based on price action and technical rules, not fundamental ones.

Whilst the discussion of these types trading goes beyond the scope and purpose of this article, it is interesting to note that the traditional broker/dealer model, whereby research analysts provide fundamental analysis based recommendations for brokers to sell and, in turn, dealers to execute, is being chipped away at by technical analysis driven, computer executed, algorithmic trading methodologies.

The growth of technology and the subsequent ease with which retail traders/investors can access the market has also given birth to a new class of people who have adopted the misguided belief that they can achieve success in the market through the use of technical analysis, despite the fact that they have very little education or experience.

And this is not entirely the fault of the individual. A large portion of the blame must be worn by the many and varied ‘operators’ out there who have hijacked technical analysis and promoted it as a means by which people can make quick and easy riches.

The quick and easy part could not be further from the truth and it is the promotion of the discipline in this way that, in my opinion, causes significant damage to new traders/investors and, as an extension of that, the discipline itself.

Technical analysis, like any other method of financial analysis, is not something which can be learnt overnight and it should never be promoted as such. It requires a considerable amount of focused learning before one might be considered competent in the area.

Once a competent level is reached, it then takes many more years of study and application before one may be considered an expert in the field. To put it in perspective, I have been studying technical analysis for five years (including both private and accredited learning) and I would consider myself just above competent. That being said, technical analysis does not necessarily require as much learning as some other areas of financial analysis which, once again, creates a double-edged sword.

To flesh out this assertion, consider the following comparison between technical analysis and fundamental analysis.

Fundamental analysis is a traditional discipline which is taught at the most prestigious business schools around the world. It involves looking at a company’s revenues, expenses, assets, liabilities and all the other financial aspects of a company in order to determine its value.

The process can and should involve in-depth analysis of the company’s balance sheet and income statement, which often requires application of some very complex mathematical formulas and quantitative models.

There is, however, more to fundamental analysis than just number crunching, which is where qualitative analysis comes in.

Qualitative analysis concerns the breakdown of all the intangible, difficult-to-measure aspects of a company. This process requires bold assumptions regarding a range of micro and macro economic considerations, many of which will simply not even be known to a retail trader/investor.

For example, understanding and quantifying the effect of proposed changes to tariff laws in a country to which the company in question exports 40% of its production, is not something retail traders/investors are likely to be able to do, let alone factor into their decision-making process.

As you may imagine, it requires many years of study to become a fundamental analyst and the performing of the discipline by a retail trader/investor who has not studied the principles is essentially impossible.

That’s right people, knowing a company’s current P/E ratio and comparing it to other stocks in the sector in order to decide whether it is cheap or expensive does NOT constitute sophisticated fundamental analysis, just as saying that a company is great because it has just printed a 52-week high does not constitute worthwhile technical analysis.

It stands to reason, therefore, that most retail traders/investors simply do not use this method of analysing financial instruments and if they do use it, they largely do so ineffectively. I certainly don’t know too many retail shop assistants, doctors, or taxi drivers who study fundamental analysis for kicks.

So, given the difficulty of both obtaining and applying the skill set required to perform fundamental analysis, people have invariably turned to other, seemingly simpler methods. One of these methods is technical analysis.

As mentioned above, there are many ‘operators’ out there who have promoted technical analysis as an easy method of mastering not only stocks, but other, more complex financial instruments. Websites with the tag lines like ‘sign-up and learn to trade like a pro’ have popped up across the internet like pimples on a teenager’s face.

In my opinion, this is extremely damaging to the discipline because it creates unrealistic expectations for new investors/traders which, inevitably, cannot be fulfilled. When these expectations are not fulfilled, it leaves many retail clients believing that technical analysis is nothing more than glorified guesswork or tea-leaf reading. And, in all honesty, I don’t blame them.

The point, however, is that technical analysis is a useful, valuable and easily accessible tool for analysing financial markets but that it should only be used after the appropriate study and research has been conducted.

Just as you would not put the knife in the hands of a first-year medical student to perform your open heart surgery, don’t think that because you have read one book or attended one seminar on technical analysis and know what a moving average is that you’re capable of utilising it to make sound trading/investing decisions.

Whilst I might seemingly have just attempted to promote technical analysis to an intellectual status beyond that of the common man, whilst at the same time eviscerate the usefulness of fundamental analysis for retail investors, that is absolutely not the intention of this article.

The intention is to encourage retail clients to develop their knowledge and skills before committing their hard-earned dollars to the market. The intention is to ensure that new traders/investors do not get caught up in get rich quick schemes. The intention is to empower you as a trader/investor.

One of the clear benefits of technical analysis is its accessibility; if you have a computer, an internet connection and access to a trading platform with decent charts, you can conduct technical analysis. You must acknowledge, however, that just because something is easily accessible it does not make its application easy. This is the one of the key themes that I am intending to convey through this article.

Let me put it another way for you.

Driving at 200km/h is easily accessible. If you have a reasonably modern car and a stretch of road, you can do it…but does this mean you should? Absolutely not. Why? Because the chances are you will hurt yourself and/or someone else.

The same applies to technical analysis and trading/investing. If you try to go 200km/h with your trading, you will put your trading account into the wall. So, before embarking upon your technically driven trading/investing career (or even if you have already begun) don’t just read one book, read many – and then read some more.

Don’t just attend one seminar; attend an intensive workshop where the presenters trade real markets, in real-time. You should even consider formal study. In Australia, FINSIA (the Financial Services Institute of Australia) offers courses in technical analysis and advanced technical analysis.

Educate yourselves people and for heaven’s sake, don’t believe the tag lines!!!

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