In a previous column, I discussed technical analysis and how it differs from fundamental analysis.
In technical analysis, it’s believed that all relevant information of a market or stock is reflected in the price, and that even with further information, it would be difficult to predict a precise market response to that information.
Instead of fundamental factors such as economic and fin-ancial data, technical analysis examines price changes over a period of time to establish trends, momentum and patterns that repeat themselves.
Technical analysis also considers the human element, which may be irrational.
For instance, if prices are declining, initially it may appear to be a buying opportunity. If prices go lower, the fear of loss may cause an investor to sell at lower prices, possibly when the buying opportunity is best.
Rising prices that appear to be selling opportunities may lead to further buying based on greed. Thus emotional mistakes can replace reason.
As technical analysis sugg-ests that investors collectively repeat the behaviour of the investors that preceded them, recognisable price patterns will develop on a chart.
In using charts, technical analysts try to identify price and market trends, and thus take advantage of them. Combined with consideration of investor sentiment, recognition of trend changes on charts can lead to profitable opportunities.
The basic properties of a chart are time scale, price scale and properties used. The time scale is normally the horizontal line, or x-axis. The time period can vary from intra-day activity to the full history.
The vertical line, or y-axis, is the price scale. It reflects the current pricing and historical price points based on the per-iod selected.
The price points may reflect the high, low and closing prices for each point in time, and are usually shown in a linear scale: that is, the price points move in absolute terms.
A chart that has logarithmic price-scale properties will have price points that move in percentage changes.
There are fundamental concepts used by technical analysts in the study of charts. The main patterns that analysts attempt to identify are reversal and continuation.
A reversal chart pattern signals that a previous trend is changing to a new trend on completion of the pattern. If the trend in price highs is lower than the previous highs, this is a bearish reversal pattern.
If the trend in price lows is higher than the previous lows, it’s a bullish reversal pattern. A reversal pattern usually signals a bottom or top, and typically occurs after a major movement in the market or a stock price.
A continuation pattern signals that a trend will continue once the pattern is complete, even if there’s a temporary deviation. Although reversal and continuation patterns can be over charts of any time frame, continuation patterns are most accurate in the medium term.
Next week, we’ll explore the concepts of support, resistance and moving averages.