One major way in which humans are different from other animal species is in our ability to communicate and transfer information via language. Our story telling prowess particularly comes in handy when we look to help others learn from the mistakes of the past. This communication also leads to communal systems, where the group tends to be more important than any individual. Another specialty of homo-sapiens is our ability to recognise patterns. This can be useful in hunting, planting crops or finding new business opportunities. These inherent human characteristics provide the underlying mechanics behind technical analysis.
The aim of the human investor is to purchase an asset and to derive a gain (income and/or capital). When it comes to assessing whether an investment will generate the right level of return, investors can lean on a few tools and techniques. The most common of these fall within the realm of fundamental analysis and involves assessing assets based on their characteristics. Information such as quality of earnings, growth and risk is used to forecast future gains and a fair price.
Alternatively, technical analysis is the use of historical market information to predict the future. This is usually done with the use of price and volume charts, with overlays of lines and figures. Using this visual representation of past price movements, technical analysts hope to make superior investment decisions without considering the drivers of profits and returns.
Key tools utilised by technical analysts include:
- Charts - Technical analysis relies heavily on visualising price data over time. With the human brain being good at recognising visual patterns, price charts offer analysts an easy way in which to guesstimate the future path of prices, based on historical movements. The usual price line graph is not the only sort of chart, with analysts adding information such as highs, lows, opening price and closing price. Other visual chart representations can remove information such as time scales or add information such as volumes.
- Trend lines - Another addition to charts are trend lines and moving averages. The latter is the connecting of key price points over time with the aim of understanding trends, momentum, reversals and break-outs. This is a primary technique utilised by technical analysts in order to understand when to buy or sell securities and at what levels to place price targets.
- Elliot waves - Utilising the mathematical features of the Fibonacci sequence (and the 'Golden ratio'), analysts use Elliot waves to try and find 'naturally-occurring' price targets. The number and sizes of the theoretical waves are used as an indicator for the way in which prices are likely to move, and thus can help the technical analyst to pick highs and lows.
Technical analysis is generally utilised in markets that have less by way of fundamentals (e.g. currencies, commodities) or in situations in which fundamental information is less useful (e.g. the short-term). In these situations, human behaviour is likely to play a bigger role, with investment price patterns being a possible outcome to be exploited. Unfortunately, the more we take advantage of these historical patterns, the more they are likely to be shared with the broader investment community and the speedier that they are likely to disappear. But, the more we fail to learn from the past, the more money that will be made from reading the tea leaves on charts.
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