Should I buy today? What will prices be tomorrow, next week, or next year? Wouldn’t investing be easy if we knew the answers to these seemingly simple questions? Alas, if you are reading this trading article in the hope that technical analysis has the answers to these questions, I’m afraid, it doesn’t. However, if you are reading this article with the hope that technical analysis will improve your investing and trading skills, I have good news, it will!
The term “technical analysis” is a complicated sounding name for a very basic approach to investing. Simply put, technical analysis is the study of prices, with charts being the primary tool.
The roots of modern-day technical analysis stem from the Dow Theory, developed around 1900 by Charles Dow. Stemming either directly or indirectly from the Dow Theory, these roots include such principles as the trending nature of prices, prices discounting all known information, confirmation and divergence, volume mirroring changes in price, and support/resistance. And of course, the widely followed Dow Jones Industrial Average is a direct offspring of the Dow Theory.
The future can be found in the past
Technical analysis is the process of analyzing a security’s historical prices in an effort to determine probable future prices. This is done by comparing current price action (i.e., current expectations) with comparable historical price action to predict a reasonable outcome. The devout technician might define this process as the fact that history repeats itself while others would suffice to say that we should learn from the past.
Contrary to popular belief, you do not need to know what a security’s price will be in the future to make money. Your goal should simply be to improve the odds of making profitable trades. Even if your analysis is as simple as determining the long-, intermediate-, and short-term trends of the security, you will have gained an edge that you would not have without technical analysis.
Consider the chart of Merck in Figure 1 where the trend is obviously down and there is no sign of a reversal. While the company may have great earnings prospects and fundamentals, it just doesn’t make sense to buy the security until there is some technical evidence in the price that this trend is changing.
Mechanical trading systems can help us remove our emotions from our decisions…That is not to say that computers aren’t wonderful technical analysis tools–they are indispensable. In my totally biased opinion, technical analysis software has done more to level the playing field for the average investor than any other non-regulatory event. I caution you not to let the software lull you into believing markets are as logical and as predictable as the computer you use to analyze them.