Understanding Technical Analysis in 500 Words

• Posted by Greg Harmon
• on April 6th, 2012

I have made some bold calls over the last 6 months or so. Some have played out and are still playing out while others sputtered or never happened. That is the way it goes with both Technical Analysis and Fundamental Analysis. Lately I’ve been getting more comments about the ones that have not worked. Many inferring that Technical Analysis (TA) must be wrong, or just not suited to some markets. This to me shows a lack of understanding about TA. Clearly I have not been doing a good enough job of adding this aspect to my work. I hit the archives since I knew I had written about this topic before and found it has been over a year (link below) so perhaps it is time to freshen it up again.

What it is

Technical Analysis at its base is an interpretation of price action plain and simple. It can be interpreted in many ways. Some use resistance and support levels based upon previous points where an asset has struggled to move higher or lower. Some use trend lines that rise or fall to glean insights into changes in buying and selling sentiment. Many look at historical patterns like triangles, wedges and channels to try to estimate how prices will react going forward. Still others look for cycles and patterns like Fibonacci ratios, seasonal factors, election cycles and longer cycles like Elliott Waves and the Kondratieff Wave for an explanation. It can get quite complex with derivatives of the price action in momentum oscillators and volatility measures. Volume can play a role as well as an indicator appetite. But no matter what tools they use all technicians are looking for an edge to give a good entry or exit on a risk reward basis for a deployment of capital. A risk framework to design a trading strategy around. A forecast. A possible future with contingencies.

What it is not

This is a subtlety many that do not practice TA fail to grasp. A possible future with contingencies. There is nothing about certainty in that statement. TA is not a road map. It does not point to an outcome. Probability is more like it. It is not fixed in time either. The read can change with changes in the price action, expected or unexpected. Nothing is certain. It can change with time. The closest thing to certainty in the TA world are horizontal support and resistance lines. They do not change, but they are also not made of concrete. Price can just as easily blow right through them or gap over them as it can be halted. And what has worked in the past may or may not work in the future.

So there you have it. The goal of Technical Analysis is to give a possible future with contingencies that can change at any time. Well that is what most will take away from this post. If you are a bit more open minded study the Masters: Steve Nison’s Japanese Candlestick Charting Techniques, 2nd Edition, Martin Pring’s Technical Analysis Explained, 4th Edition, Robert Prechter’s Elliott Wave Principle, Tenth Edition and the bible of TA, Edwards & Magee’s Technical Analysis of Stock Trends, 9th Edition as a start.

January 12, 2011: TA is About Reflection, not Inflection

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