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Primer on Technical Analysis

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While technical and fundamental analyses share commonalities, here's why technical analysis cuts out the middle man.

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Editor's Note: See Jason Haver's corresponding article Technical Analysis: Basics of Elliott Wave Theory. Also see his most recent market update, Bears Fire Warning Shot Across the (S&P) Bow.

MINYANVILLE ORIGINAL In a series of articles, I'm going to attempt to explain some basics about market analysis, with a focus on Elliott Wave Theory.

Later in the series, I'll share some ways to utilize these tools for your own benefit. A small portion of this has been reprinted from some of my earlier articles, so if it sounds familiar, that's because I plagiarized myself. My attorney assures me that I am immune from litigation, but I have filed suit against myself anyway, because I can't have people stealing my work!

First, I want to briefly address fundamental analysis.

My primary focus as a trader involves technical analysis, for reasons I will explain shortly, however, unlike many technical analysts, I do believe that fundamental analysis has value. I believe it serves as a foundation to interpreting charts across longer time-frames, and aids in understanding what is possible and likely.

Conversely, some fundamental analysts seem to believe that projecting the market using price charts is some kind of "voodoo." I suppose this is understandable; most things we don't understand carry a certain mystique to them. It's important to realize that price charts, all by themselves, contain all the collective knowledge about a stock or index.

People act on what they know or believe, so it stands to reason that people buy or sell securities based on what they know and believe -- thus (and here's the critical point about technical analysis) everything known about a given security by all the shareholders collectively is reflected in a price chart. When an insider makes a trade, it influences the price of that security, and leaves a clue which can be read on the chart. When a huge hedge fund gains a piece of critical information (usually well ahead of the public) and starts buying or selling a specific stock or commodity, that action leaves its mark on the charts… and so on. Thus the charts point the way ahead.

The fundamental analyst and the technical analyst (one who studies charts) share the same goal: Both seek to project the future.

Their methods are also quite similar in many respects. For example, a fundamental analyst might look at Apple (AAPL) and try to project how many iPhones and iWidgets will be sold next quarter, and how that will influence profits, growth, etc. Then he takes all his research numbers and derives a projection of the company's outlook -- largely based on what's happened in the past. He then plugs that projection into a formula to arrive at a future share price target, which is also based on how things have performed in the past.

A technical analyst does the same thing, except he looks at the charts directly (which, as we just learned, contain all the knowledge of the collective) and cuts out the middle man. He seeks patterns which convey information: When price has moved up by x number of dollars, and then moved down by x percent to create a certain pattern? How has the market usually performed in the past?

Both forms of analysis are based on past performance and on future probability – they just get there by different means.

The weakness to fundamental analysis is that there are a great many variables which the analyst simply cannot foresee. Study what happened in 2007-2008 for an example. Many stocks looked great, and projected earnings looked great, and their futures looked so bright that everyone was wearing shades – but their share prices collapsed anyway, in a spectacular fashion. In September 2008, did anybody care about how many iWidgets any given company was projected to sell in the fourth quarter of that year?

Some fundamental analysts saw what was coming back then; others didn't. Likewise, some technical analysts saw what was coming (myself included) and others didn't. But the probability of a crash was all telegraphed well in advance on the price charts – one didn't even need to turn on the TV to see it coming ahead of time.

The big advantage to technical analysis: Technical analysts were able to arrive at actual price targets for the crash, in real time, while it unfolded.

Fundamental analysts knew it was "gonna be bad!" but that type of analysis doesn't help time the market with a large degree of accuracy. This is why the majority of fundamental analysts don't even try to time the market, except in broad strokes; their system is ill-suited to it.

Next, we'll look at Elliott Wave Theory.

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No positions in stocks mentioned.
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