Technical analysis involves the examination of past market data, such as prices and volume of trading, that leads to an estimate of future price trends and, therefore, investment decisions. Several assumptions lead to this view of price movements:

• The market value of any good or service is determined solely by the interaction of supply and demand.

• Supply and demand are governed by numerous rational and irrational (such as moods, guesses and opinions) factors. The market weighs all these factors continuously and automatically.

• The prices for individual securities and the overall value of the market tend to move in trends, which persist for appreciable lengths of time. That is, the new information enters the market over a period of time, leading to a gradual adjustment of stock prices.

• Prevailing trends change in reaction to shifts in the supply and demand relationship. These shifts can be detected sooner or later in the action of the market itself.

Technical Analysis and Behavioral Finance

Behavioral Finance studies why market participants make the decisions they do when interacting with the financial markets. Market participants, being humans (or algorithms programmed by humans), are influenced by cognitive biases, and those biases will tend to make them do things such as over-reacting to market information, or making errors such as taking profits early or holding on to losing positions.

Technical Analysis is the methodology used to measure these occurrences. Price patterns such as trends, volatility changes, bubbles and crashes will tend to repeat, as human nature remains largely the same over time. If a pattern that precedes a profitable outcome can be detected with a degree of probability using technical analysis, this information can be used to make returns from the market in the future.

Technical and Fundamental Analysis

Technical analysis and fundamental analysis are equally useful and valid, but they approach the market in different ways. Fundamental analysis involves making investment decisions based on examination of the economy, an industry, and company variables that lead to an estimate of value for an investment, which is then compared to the prevailing market price of the investment.

Although both types of analysis agree that the price of a security is determined by the interaction of supply and demand, technical analysts and fundamental analysts have different opinions on the influence of irrational factors. A technical analyst might expect the irrational influence to persist for some time, whereas other market analysts would expect only a short-run effect with rational beliefs prevailing over the long run.

A bigger difference exists between the two regarding the speed of adjustments of stock prices to changes in supply and demand. Technical analysts believe that new information comes to the market over a period of time because of different sources of information or because certain investors receive information or perceive fundamental changes earlier than others. Based on this belief, they expect stock prices to move in trends that persist for long periods, a gradual price adjustment reflecting the gradual flow of the information. Fundamental analysts, however, believe that new information comes to the market very quickly and they expect stock prices to change abruptly.

Technical analysts claim that their method is not heavily dependent on financial accounting statements, which have several major problems:

• Financial statements lack a great deal of information that security analysts need.
• Alternative accounting procedures can produce vastly different values for expenses, income, and return on assets. Comparing two firms in the same industry is sometimes problematic.
• Many psychological factors and other non-quantifiable variables do not appear in financial statements.

To summarize the differences:

• How do they make investment decisions?
  • Technical analysts make investment decisions by examining past market data to estimate future price trends. They identify new trends and take appropriate actions.
  • Fundamental analysts make investment decisions by examining the economy, the industry, and the company to estimate the intrinsic value of a stock. They then compare the intrinsic value to the prevailing market price and take actions.

• What data do they use?
  • Technical analysts use market data and nonquantifiable variables such as psychological factors.
  • Fundamental analysts use economic data (including accounting data, which is subject to management manipulation).

The usefulness of technical analysis is diminished by any constraints on the security being freely traded, by large outside manipulation of the market, and in illiquid markets.

Practice Question 1

Technical analysis is most widely accepted by ______ and usually rejected by ______.

A. academicians; practitioners
B. practitioners; academicians
C. traders; academicians

Correct Answer: C

Academic research indicates that, on average, you cannot outperform the market on a risk-adjusted basis. Statistics also say prices are independent, which causes rejection of technical analysis.

Practice Question 2

Which of the following are basic assumptions of technical analysis?

I. Market value is determined solely by supply and demand.
II. Irrational and rational factors govern market values.
III. Reversals of trends are caused by shifts in supply and demand.
IV. Many chart patterns tend to repeat themselves.

Correct Answer: I, II, III and IV

Technical analysis: an analysis of price and volume data as well as other related market indicators to determine past trends that are believed to be predictable into the future. Charts and graphs are often utilized.

Practice Question 3

Technical analysts rely on ______ to predict future stock prices.

A. future earnings forecasts
B. past movements in stock prices
C. future earnings forecasts and past movements in stock prices

Correct Answer: B

Technical analysts believe that the only information needed to estimate future prices is past prices.

Practice Question 4

Technical analysis assumes that ______

A. trends in security prices do not persist.
B. trends in security prices do persist.
C. trends in security prices do persist, but the persistence is not important.

Correct Answer: B

Persistence in stock prices is critical to applying technical analysis to identify undervalued securities.

Practice Question 5

Examination of a firm's accounting statements and other financial information to assess the economic value of a company's stock is called ______.

A. security analysis
B. fundamental analysis
C. stock investigation

Correct Answer: B

Economic value determination is the fundamental goal of accounting and financial information analysis.

Practice Question 6

Technical analysts and fundamental analysts ______.

A. agree on the basic assumptions underlying changes in stock prices
B. differ in their beliefs about how information impacts stock prices
C. both believe in the efficient markets hypothesis

Correct Answer: B

Fundamental analysts believe that stock prices immediately reflect new information, leading to random fluctuation in stock prices. Technical analysts believe that stock prices adjust gradually, leading to predictable trends in security prices.

Practice Question 7

Technical analysis has the following advantage over fundamental analysis ______.

I. easier timing
II. no reliance on accounting statements
III. no need to process information ahead of other investors

Correct Answer: I, II and III

Practice Question 8

A technical analyst would argue that accounting statements ______.

I. are not needed to make investment decisions
II. are incomplete
III. are governed by GAAP

Correct Answer: I, II and III

Technical analysts believe that accounting statements, governed by GAAP, are incomplete and are not necessary to make investment decisions because only past price movements are relevant.

Practice Question 9

Technical analysis is ______ than fundamental analysis.

A. easier
B. more difficult
C. more effective

Correct Answer: A

Technical analysis relies only on the analysis of past price and possibly volume data; therefore, it is generally regarded as being simpler and easier than fundamental analysis. There is no evidence that technical analysis is more effective.

Practice Question 10

Technical analysis is often challenged on the grounds of ______.

I. its assumptions
II. its technical trading rules

Correct Answer: I and II

Practice Question 11

If weak form market efficiency holds, then ______

A. technical analysis does not work.
B. technical analysis works.
C. fundamental analysis does not work.

Correct Answer: A

Tests of weak form market efficiency examine whether it is possible to earn superior returns by examining only past price data.

Practice Question 12

A criticism of technical analysis trading rules is that ______

I. they are often subjective.
II. they may become self-fulfilling prophecies.
III. they may change over time.

Correct Answer: I, II and III

Practice Question 13

Which group of analysts uses earnings and dividend prospects of a firm to determine proper stock price?

A. technical analysts
B. equity analysts
C. fundamental analysts

Correct Answer: C

Practice Question 14

Two basic assumptions of technical analysis are that ______

A. security prices adjust rapidly to new information and market prices are determined by the interaction of supply and demand.
B. security prices adjust gradually to new information and liquidity is provided by securities dealers.
C. security prices adjust gradually to new information and market prices are determined by the interaction of supply and demand.

Correct Answer: C

Technical analysis assumes that prices can be projected with charts and other technical tools.

Practice Question 15

A basic assumption of technical analysis in contrast to fundamental analysis is that ______

A. financial statements provide information crucial in valuing a stock.
B. aggregate supply of and demand for goods and services are key determinants of stock value.
C. security prices move in patterns which repeat over long periods.

Correct Answer: C

Technical analysis assumes that patterns are repeatable and prices can be projected.

Practice Question 16

Which of the following are underlying assumptions of technical analysis?

I. Past performance has no influence on future performance or market values.
II. Security prices adjust rapidly to stock market information.
III. Security prices move in trends, which persist for appreciable lengths of time.
IV. The market value of any good or service is determined solely by the interaction of supply and demand for the good or service.

A. I and IV only
B. II and III only
C. III and IV only

Correct Answer: C

Practice Question 17

Technical analysis assumes that shifts in trends can be detected sooner or later in the action of the ______.

A. investment managers
B. market
C. both of these answers

Correct Answer: B

The four assumptions that support technical analysis are these:

1. The market value of any good or service is determined solely by the interaction of supply and demand for it.
2. Supply and demand are governed by numerous factors, both rational and irrational, including the economic variables relied upon by the fundamental analyst as well as opinions, models, and guesses. The market weighs all of these factors continually and automatically.
3. Disregarding minor fluctuations, the prices for individual securities and the overall value of the market tend to move in trends, which persist for appreciable lengths of time.
4. Prevailing trends change in reaction to shifts in supply and demand relationships. These shifts, no matter why they occur, can be detected sooner or later in the action of the market itself.

Practice Question 18

Followers of technical analysis believe ALL of the following EXCEPT ______

A. there is no need to conduct fundamental analysis.
B. new information arrives randomly in the market.
C. it is important to move quickly or be one of the first to exploit trading opportunities.

Correct Answer: B

Technical analysts believe that information does not arrive randomly and that the market takes time to process it. With serial correlation in new information, trends develop that can be exploited. A trader does not have to be the first one to jump into the market, as the price trend tells the trader which way the market is headed.

Practice Question 19

Technicians do NOT believe ______

A. trends and patterns are somewhat predictable.
B. fundamental analysis is a key input in determining security prices.
C. security price movements occur after fundamental developments unfold.

Correct Answer: C

A: They believe trends and patterns tend to repeat themselves.

B: They believe this statement but they also believe that fundamental analysis is not the only determinant.

C: They believe that security price movements occur before fundamental developments unfold.

Practice Question 20

Which statement is false regarding technical analysis?

A. Some applications of technical analysis are subjective.
B. Technical analysis of any financial instrument requires detailed knowledge of that instrument.
C. A key shortcoming of technical analysis is that it can be late in identifying changes in trends or patterns.

Correct Answer: B

A is true. The interpretation of findings is often subjective.

B is false. A technician just needs the chart that represents the action in a freely traded market.

C is also true.

Practice Question 21

______ seek to project the level at which a financial instrument will trade, and ______ seek to predict where it should trade.

A. Technicians; fundamental analysts
B. Fundamental analysts; technicians
C. Technicians; technicians

Correct Answer: A

A technician studies the markets and financial instruments as they exist.