to persist until there is evidence to the contrary. Hence a state of persistence is assumed to be the status quo. If a cycle is identified, it is assumed to persist until cyclic failure is clear and obvious. If the market is in consolidation, it is expected to continue to range until a breakout is identified.
The second premise is also a fairly obvious, not only in relation to technical analysis but also with much of life. For example, an analyst may make a case for rising oil prices as the reason for a rise in the Dow Jones index since it is indicative of increasing demand, representing evidence of a recovering economy. The same analyst may also make a case for rising oil prices as the reason for a decline in the Dow Jones index due to the widely held perception of increasing cost, and hence bearish for the economy in general. Another example would be to find the stochastics at an oversold level and conclude that the current uptrend is strong since it is potentially or implicitly bullish. Alternatively, the stochastics could be at an overbought level, leading to the conclusion that the current uptrend is strong since an overbought level is regarded as explicitly bullish.
The third premise above is obvious when using oscillators such as stochastics, RSI, and MACD. A reading of 100 percent on the stochastics is extremely and explicitly bullish but it is also regarded as a potentially or implicitly bearish condition since it is at a level where price may generally be regarded as being overextended or exhausted. There is an underlying expectation or assumption that a reversion to the means would eventually take place (note that this may not always be true, for example, in the case of cumulative type indicators). A breakout above a rising channel is also explicitly bullish but it is also regarded as implicitly bearish since it also represents a state of overextension or exhaustion in price, with respect to the rising channel formation.
The fourth premise is specifically about the effects of the self-fulfilling prophecy. It is easy to understand why a largely concerted wave of buying or selling at various points on a price chart may cause a significant reaction in price. This concerted wave of buying or selling will generally be more pronounced if these points are significantly clear and obvious to most market participants using technical analysis. Hence we generally notice a larger than average penetration bar during trendline breakouts, especially if the trendline is significantly clear and obvious to most traders. This also implies that should an indicator be essentially faulty or illogical in its design, if enough participants risk actual capital based on its signals, it would begin to exhibit a greater level of reliability.
The Efficacy of Technical Analysis at Various Timeframes
Technical analysis generally works more efficiently at timeframes where there are fewer forms of analyses available. For example, on higher timeframes like the daily, weekly, monthly, or yearly charts, fundamental analysis plays a very important role in helping to forecast potential market action. But at very low timeframes like the one-minute charts, fundamental analysis may not be as useful, especially if the stopsize is very small. In essence, the smaller the stopsize, the more important will be the role of applying technical analysis when trying to forecast very short term movements in price. This is the main reason why technical analysis is generally more reliable at lower timeframes.
1.8 MARKET PARTICIPANTS
Market participants comprise the average investors and traders, financial institutions, commercial and central banks, hedgers, arbitrageurs, brokers, hedge funds, mutual and pension funds, and so on. Here are the eight main categories of market participants:
1. Retail
2. Institutional
3. Speculator
4. Supply Side
5. Demand Side
6. Professional
7. Investor
8. Novice
Market participants may also be categorized as:
• Discretionary Traders
• Nondiscretionary Traders
But there are many other ways of categorizing market participants. We can categorize them by the amount of time they spend in the markets or by the methodology that they employ when trading or investing in the markets. Figure 1.33 lists the five main groups of market participants by the amount of time they spend in the markets.
Figure 1.33 Market Participants by Way of Time Spent in the Markets.
Figure 1.34 lists the same five groups of market participants by way of the methodology that they employ when trading or investing in the markets.
Figure 1.34 Market Participants by Way of Trading and Investing Methodology.
Popular Markets and Instruments
Market participants may trade and invest in either the main markets or instruments that allow access to these markets. These instruments are also referred to as derivatives, since they are derived from the main underlying markets. For example, a market participant may participate in gold in several ways:
• By buying the physical Gold itself (main market)
• By buying or selling a futures contract on Gold (derivative)
• By buying or selling an options contract on Gold (derivative)
• By investing in Gold-backed ETF shares (derivative)
• By investing and trading Gold via contracts for difference (CFD) (derivative)
See Figure 1.35 for a visual summary of popular markets and their derivatives.
Figure 1.35 Popular Markets and Instruments.
1.9 CHAPTER SUMMARY
Technical analysis is the study of market action. It is an extremely popular approach in gauging potential market moves as well as identifying past activity in terms of patterns, proportions, and time. It involves the study of price action, volume and open interest action, market breadth, sentiment data, and the flow of funds. It attempts to identify potentially repetitive patterns in the form of chart and bar formations, price cycles, and seasonality, based on the assumption that there is some reliable degree of repeatability associated with these technical formations.
We shall delve more deeply into these aspects of technical analysis over the rest of this handbook.
CHAPTER 1 REVIEW QUESTIONS
1. What are the challenges to technical analysis?
2. A basic assumption in technical analysis is that the market discounts everything. EMH also requires the discounting of all information. In what ways are they different?
3. Describe how an analyst may resolve conflicting signals or chart patterns.
4. Explain why identifying a trend change is largely a subjective exercise.
5. Is random walk a true reflection of the markets?
6. Describe the three levels of discounting new information under EMH.
7. What is a good definition of technical analysis?
8. List as many advantages and disadvantages of using technical analysis as you can.
REFERENCES
Edwards, Robert D., and John Magee. 2007. Technical Analysis of Stock Trends. New York: AMACOM).
Kirkpatrick, Charles, and Julie Dahlquist. 2007. Technical Analysis: The Complete Resource for Financial Market Technicians. Upper Saddle River, NJ: Pearson Education Inc.
Murphy, John. 1999. Technical Analysis of the Financial Markets. (New York: New York Institute of Finance (NYIF).
Pring,