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Thursday, August 19, 2010

Assumption of Technical Analysis

"The future influences the present just as much as the past." - Friedrich Nietzsche (1844 - 1900)

Technical Analysis is built on some fundamental assumptions in regards to the fashion in which a market operates. These assumptions are not only integral to you as an aspiring Technical Analyst, but are also central to Technical Analysis as a theory.

In summary, these assumptions include:

1. Price discounts everything.

2. Prices usually always move in trends and

3. History repeats itself over time.

A more detailed explanation of these assumptions will now be explored.

Price Discounts Everything

What exactly does this mean? In a nut shell, this first assumption seeks to incorporate all the fundamental, political, macro and micro economic data as well as the risk component of a stock into the current market price at any one period.

This infers that the market price can be heavily influenced by an investor's perception of supply and demand, as well as the general broad economic overview at the time the price is captured.

Therefore, it can be assumed that Technical Analysts believe that the current market price of a stock reflects all the relatively important information that Fundamental Analysts are seeking to provide qualitative and quantitative explanations for.

This is one of the key reasons that Technical Analysts do not focus on the underlying data behind price variation, but rather focus on what the market is valuing the stock at.

Prices usually always Move in Trends

Prices usually occur in Trends, although some theorists argue that prices are completed random. Randomness of price is specifically related to the Efficient Market Hypothesis. This theory is based on the fact that markets are "efficient" and information dissemination occurs instantaneously across the market.

In the real world however, this is never entirely achievable because of a varying number of factors and therefore complete randomness -- in its true form -- is never absolutely reflected.

Quite simply, the more efficient a market becomes, the faster information is dispersed to the market and as a consequence, the faster price changes to reflect this information.

From a charting perspective, this infers that prices follow a distinctly more "step-like-pattern" as opposed to a smooth trend for inefficient markets. In consideration of this, prices can only adjust as fast as the news spreads across the market. It is important to realize that there is a subtle difference between information being available to the market, and investors actually processing this information to act rationally upon it.

Equally, since different investors have different risk preferences it infers that their reactions to this information will vary and increase the level of randomness in the market.

Those that have had several years experience in the market will be able to differentiate between these factors and as a consequence, will know which stocks will trend in patterns and which will not.

History Repeats Itself over Time

The psychology of trading and human nature in general is based on emotional factors. Pride, greed, hope, anger, sadness and ego are all factors that affect the market place as much as they do our normal lives. Even if some investors are completely risk adverse and others are risk tolerant - these factors all have a substantial impact on the decision making process you adopt.

If you wrote down all the goals you seek to achieve in your trading strategy, you would find that the majority relate in some way to making a profit.

Is this a bad thing?

It could be argued that either side of this argument will present differing strengths and weaknesses. The most significant factor to realize is that you are not the only person motivated by profit. All traders tend to react in the same way each time they encounter a situation which is similar.

While it is true that some traders react positively from any mistakes made and learn from them, other participants decide to leave the market and therefore create a balancing pendulum of traders entering and leaving the market.

Consequently, the same oversights are made by each generation of traders in the market which infers that history tends to repeat itself as time moves forward.

Another important market factor to consider is that most people act like sheep when it comes to a trading situation - "once the flock begins to move, all the other sheep follow."

So what? You ask, How Does this Affect Me?

Quite simply, all our emotions tell us to follow what the majority of people are doing and as a result we are heavily influenced by market majority. This idea of "majority rules" negatively affects trading interpretations because it adversely influences what degree we interpret both buyers? and sellers? nature in the market and how they are reacting to a situation. This then persuades our judgment about future price direction and our independency of making market decisions.