The world of day trading is a gamble at best, and many theories abound about what exactly governs the financial marketplace. While technical analysis of the market is considered by many academics to be a murky pseudoscience, many traders consider it to be a time honored and proven practice with applications that extend predicting stock trends to futures trading and even financial spread betting.
Technical Analysis, Predicting Stock Trends
Technical analysis is a method that principally relies on the reading of charts and graphs to determine trends in financial markets. Technical analysis largely ignores the other school of financial thought, fundamental analysis, which accounts for the actual nature of the entities operating in the marketplace (companies, currencies, commodities, etc).
Technical analysis seeks to identify price patterns and other trends using market indicators. Technicians try to forecast price movements in a way that large gains in price outweigh numerous small drops. Thus its important to identify not only which way prices are trending, but when these price patterns will change.
Technical Analysis Theory
There are three distinct schools of technical analysis, candlestick charting, Dow Theory, and Elliot Wave. While the average day trader utilizes techniques from all three of these schools, each has its own distinct view on how to predict stock trends in the market.
Candlestick charting is the earliest of these schools and employs a simple graph that uses bars called candlesticks to denote trends. Dow Theory is largely influential in the creation of technical analysis during the 19th century and pioneered the view of looking at shifts in price as patterns that could be broken down into specific phases. Dow first espoused the belief that the market discounted all information. Elliot Wave Theory is the newest school and proposes that market patterns occur in a historical cycle based on the mass behavior of individual investors.
The science of technical analysis often involves technicians using a combination of judgment and experience to determine which indicators reflect any one of these three schools.
Technical Analysis Applications
Many day traders believe that trading in the direction of the trend is the most effective way to make money in the market. Thus many algorithmic trading systems like pension funds and mutual funds are developing automated trading strategies that rely heavily upon the principles of technical analysis. Neural networks are designed to mimic the way biological neural networks operate. Their use in the financial sector is growing in popularity because of their ability to recognize complex data patterns. While their real world application is still highly theoretical, one day neural networks could eliminate the need for human technical analysis
Rules based trading is another approach that utilizes trading-plans with clear cut rules about how the trader will operate. While still using some of the principles of technical analysis, it determines a set of rules that defines every trade the investor makes, taking emotion out of the process and minimizing potential human errors.
Many traders and researchers are using technical analysis in combination with other techniques such as quantitative analysis and economic theory to better understand market interactions on a global scale.
While technical analysis is growing in legitimacy in both the academic and financial world, the jury is still out on how effective these techniques truly are at predicting market trends.
Sources:
Technical Analysis Explained: The Successful Investor's Guide to Spotting Investment Trends and Turning Points, Martin J. Pring, McGraw Hill, 2002
Technical Analysis of Stock Trends, 9th Edition, Robert D. Edwards, John Magee, W.H.C. Bassetti (Editor), American Management Association, 2007
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