Technical Analysis: The basics

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If you are new to investing, you may be puzzled by the store many investors set on interpreting share price charts. At the most basic level, there are several reasons why this happens.

The first is that a chart is an easy visual representation of the recent past history of a share price. It may show a price at an all-time high, or at a low ebb. It may show sharp spikes up or down at particular points in time, often as a result of some underlying fundamental cause.

The second reason is that dyed in the wool 'market technicians', as chart experts like to call themselves, argue that because the market represents the free flow of information and the actions, backed up by hard cash, of many buyers and sellers, market prices and therefore price charts, discount all of the information available.

Hence the price chart can be used as an infallible guide to market sentiment. There is no need to look at the fundamentals, because all of the known information is, so to speak 'in the price'.

This is a naïve interpretation of the way the stockmarket works.

It may be true in some markets, like foreign exchange, where shortvterm trading dominates and instruments to trade are relatively few in number. But in a market with 3,000 different shares, there are bound to be anomalies among those that are less prominent and less actively traded. And with anomalies come opportunities for outperformance and the ability to select shares on valuation criteria based on accounting data and other fundamental factors.

However, that is not to say that charting lacks intellectual rigour.

Many chart techniques are based around interpreting cyclical patterns, using statistically proven techniques. Moving averages, for example, are a classic way of filtering out short term 'noise' from individual share prices. Confidence limits, calculated using regression analysis and standard deviation numbers, are a way of setting boundaries to a fluctuating share price, beyond which it should become unsustainably cheap or expensive with a degree of statistical certainty.

Investor psychology

And interpretation of charts looking at support and resistance levels reflects investor psychology. These zones exist because of our reluctance, for example, to sell until a losing share gets back to the price we paid for it, or to pay more for a share that has shot up after we bought, until it comes down to a more 'reasonable' level.

Charts used to be drawn by hand, but computers have replaced paper charts, and make the calculation of sophisticated technical indicators easily done. Those who wish to make decisions exclusively using technical analysis may, however, find it a frustrating discipline. Even the most detailed technical analysis cannot legislate for new and shocking information, good news or bad, that changes perceptions overnight. Think of BP's (BP.) Gulf of Mexico oil spill, or the recent Japanese earthquake, for example.

In addition the advent of new trading methods, such as exchange traded funds, have made it possible to perform accurate asset allocation decisions, and moreover to tailor portfolio volatility precisely, without bearing any stock specific risk that serious technical analysis might be used to avoid or minimise.

More and more investors are (or should be) trying to think seriously about asset allocation in this way, because correct asset allocation trumps stock picking every time - at least for long term investors.

Technical analysis isn't redundant though. It can be used successfully in commodity and currency markets. Exchange traded products in these areas allow traders to get unleveraged exposure quickly and easily on the back of decisions based around technical indicators.

In short, it is perhaps true to say that technical analysis as practised in days gone by may have been superseded by a more holistic approach to that part of portfolio management and trading that excludes fundamentals. It is an approach that borrows concepts such as noise filtering, reversion to the mean, stochastics and other technical concepts and mingles them with volatility calculation, and macro economic factors to try and create optimal asset allocation.

It's a far cry of ink-stained fingers, grubby paper charts, and complex calculations done by slide rules or hand cranked calculators, but none the worse for that.