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The market is undoubtedly driven by people, and technical analysis is one way to analyze and predict this behavior.

My question (also the title) is "Is technical analysis based on some underlying factors in the market or do they work simply because other people use them?". What I mean is, are the popular of the methods of technical analysis, such as the stochastic oscillator, moving averages, Bollinger bands, and Fibonacci lines based on some truth, value, or such factor underlying in the market; or do the such methods of technical analysis only hold any purpose simply because other people use them, and therefore drive the market.

Another way to phrase the question, that might help clarify my point, is: if other people did not have access or knowledge of the methods of technical analysis, would the methods still have any predictive capabilities?

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    If anything, the more people who apply such methods, the less value they will have, because people's reactions to such indicators will cause market movements that disrupt the indicators they are reacting to. – BrenBarn Oct 16 '15 at 7:59
  • @BrenBarn, does this remain true for Fibonacci lines, or are they a self-fulfilling prophesy? How would Fibonacci apply at all to a market, if no one else applied it? – Mee Oct 16 '15 at 8:36
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Technical analysis is based more on psychology than anything else. As an example, if an analyst estimates or believes that a stock is undervalued, or simply wants to re-balance their portfolio, then they will buy some amount, moving the price up. Others in the market see the upwards move as the start of an upwards trend, an indication that the stock is undervalued or perhaps even that an insider is trading ahead of better than expected data from the firm. They then buy the stock creating a self-fulfilling prophecy and pulling more traders in as they see an upward trend being confirmed.

This is even more pronounced in a bear market as fear is an even stronger driver. When a trader sees a stock is falling they are more likely to jump to the conclusion that it is due to expected poor performance of the firm and that the firm and the economy are both in trouble and going down than to think that it is simply a retrenching or a large investor re-balancing etc.

To quote Credit Suisse [1]

A chart is a mirror of the mood of the crowd and not of the fundamental factors. Thus, technical analysis is the analysis of human mass psychology. Therefore, it is also called behavioral finance.

The underlying truth that makes technical analysis work is that people are predictably irrational, at least in the short run and tend to follow the same patterns of thought.

references:

[1] https://www.credit-suisse.com/pwp/pb/pb_research/technical_tutorial_de.pdf

[2] http://www.amazon.com/The-Psychology-Technical-Analysis-Profiting/dp/1557385432

[3] CFA level 1 syllabus

  • Thanks for the part about behavioral finance. I now know that technical analysis is behavioral finance. – Mee Oct 16 '15 at 8:33
  • my pleasure. In case you're wondering although I used to I'm not allowed to trade on technical analysis any more since I now work for a trade monitoring company who check that everything is being done legally and ethically! – MD-Tech Oct 16 '15 at 8:38
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Both explanations are partly true.

There are many investors who do not want to sell an asset at a loss. This causes "resistance" at prices where large amounts of the asset were previously traded by such investors. It also explains why a "break-through" of such a "resistance" is often associated with a substantial "move" in price.

There are also many investors who have "stop-loss" or "trailing stop-loss" "limit orders" in effect. These investors will automatically sell out of a long position (or buy out of a short position) if the price drops (or rises) by a certain percentage (typically 8% - 10%).

There are periods of time when money is flowing into an asset or asset class. This could be due to a large investor trying to quietly purchase the asset in a way that avoids raising the price earlier than necessary. Or perhaps a large investor is dollar-cost-averaging. Or perhaps a legal mandate for a category of investors has changed, and they need to rebalance their portfolios. This rebalancing is likely to take place over time. Or perhaps there is a fad where many small investors (at various times) decide to increase (or decrease) their stake in an asset class. Or perhaps (for demographic reasons) the number of investors in a particular situation is increasing, so there are more investors who want to make particular investments. All of these phenomena can be summarized by the word "momentum".

Traders who use technical analysis (including most day traders and algorithmic speculators) are aware of these phenomena. They are therefore more likely to purchase (or sell, or short) an asset shortly after one of their "buy signals" or "sell signals" is triggered. This reinforces the phenomena.

There are also poorly-understood long-term cycles that affect business fundamentals and/or the politics that constrain business activity. For example:

  • The sun has multi-year cycles (called "sunspot cycles") that affect the weather -- and thus farming and other economic activity.
  • The oceans have multi-year cycles that also affect the weather.
  • Regularly scheduled elections in two-party countries result in alternating government policies.
  • The first world is seeing demographic waves. The most noted effect is the alternation of births of descendents of people born in during 1930-1944 vs. 1945-1960.

Note that even if the markets really were a random walk, it would still be profitable (and risk-reducing) to perform dollar-cost-averaging when buying into a position, and also perform averaging when selling out of a position. But this means that recent investor behavior can be used to predict the near-future behavior of investors, which justifies technical analysis.

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Technical Analysis assumes that the only relevant number(s) regarding a security is (are) price (and price momentum, price patterns, price harmonics, price trends, price aberrations, etc.). Technical is all based on price. Technical is not based on any of the fundamentals.

Technical Analysis is for traders (speculators) not for long term investors. A long term investor is more concerned with the dividend payment history and such similar data as he makes his money from the dividend payments not from the changes in price (because he buys and holds, not buy low sell high).

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