The background of technical analysis of the financial markets

There are a few different ways to analyse a financial market. You might look at the underlying performance of the company, sector or stock. This fundamental analysis will tell you why something is happening.

Or you might decide that the price of the stock is a summary for all that background information. The analysis of a stock’s price movement over time is termed technical analysis (TA). It’s most common in the commodities and FOREX markets where short-term price movement is more significant than in stocks and futures, for instance. Technical analysis aims to tell us when something is happening.

If you like charts and equations, this is your happy place. Just be thankful we don’t have to construct those charts by hand any more. Proponents of technical analysis in financial markets say investigating price trends will build a picture of market sentiment, whether those trends are over the short-, medium-, or long term. That said, many use technical analysis for short-term market conditions, preferring fundamental analysis for a long-term perspective.

What kind of indicators are we talking about?

Technical analysis of the financial markets has been in use for more than 100 years, during which time many different indicators have been developed. For example, you have chart patterns, volume and momentum indicators, oscillators (like the Relative Strength Index or the Bollinger Bands), various moving average indicators, and support and resistance levels.

Technical analysis is underpinning assumptions

If you use technical analysis you accept the premise that the markets work in predictable ways, that past performance predicts future options.

While market activity is driven by human psychology we can see why this is a beguiling factor and somewhat true – witness the way that market behavior swings between bull and bear markets for instance. But we know that random things do happen, whether driven by market manipulation or not. Technical analysis of the financial markets doesn’t account for both the predictable and the unexpected. After all, it is fundamentally human beings that move the market, not computers using mathematical formulae.

Other failings and flaws of technical analysis

Critics of this kind of approach point out that technical analysis creates a self-fulfilling prophecy: if a large number of traders use the same indicators to predict market movement and they act accordingly, those indicators end up working because the number of people using them will have made the market moves they inspired.

Technical analysis of the financial markets is not universally effective: it works best in high-volume, liquid markets that are less likely to have unpredictable external influences that could create false signals, rendering it misleading. Some traders see it as being unreliable.

A fundamental flaw of technical analysis is that by the time the analysis has concluded, the market has already moved on. You might be three to five bars behind and miss the main part of the move. That’s why, quite often, the market moves in the opposite direction to that which your TA indicators told you to act.

Have you considered Wyckoff Volume Spread Analysis (VSA)?

If you’ve considered using Wyckoff Volume Spread Analysis in your trading, which identifies market moves in foresight not hindsight, take a look at the Tradeguider YouTube channel to see the trading system in action. Learn how Wyckoff VSA works and how it differs from technical analysis.