Technical Analysis and the Efficient Market HypothesisTechnical analysis is known as the study and the use of charts to identify patterns and trends for the purpose of forecasting the future price of an asset. Many academics have initially discounted the usefulness of technical analysis and claimed that asset prices fluctuate in a random manner under the Efficient Market Hypothesis. They claimed that past prices and volumes cannot be used to forecast future movements.
However, over the years, there are a growing number of empirical studies and evidences that support the theory that the market does not follow a "Random Walk". This basically questions the complete validity of the Efficient Market Hypothesis. Some examples of these studies are the "Small Firm Effect" (The theory where smaller companies have a greater amount of growth than larger companies), P/E Effect" (The theory where low P/E stocks have higher returns) and the "January Effect" (The theory where stock prices go up in the month of January).
It is also important to note that some of the most notable and influential investors of our times also do not believe that the market is efficient at all times.
Importance of Technical AnalysisIn recent years, technical analysis has grown to become very popular. One of the reasons for this growth is attributed to the number of books written on the subject. A better understanding of technical analysis allows more people to apply the concepts and theories in their trading. Another reason for the growing importance of technical analysis is due to the popularity of trend trading system and swing trading system which both uses technical indicators. In trend trading, technical indicators are used to catch a particular trend of certain specific asset. In swing trading, the investor uses a combination of fundamental information and technical analysis in their selection of assets.
The growing acceptance of technical analysis is also manifested in the number of schools and universities that offer accredited training. Even the CFA (Chartered Financial Analyst) program includes modules on Technical Analysis.
Types of Technical IndicatorsThere are many types of technical indicators but they can be generally classified into four different categories. The categories include those that measure the momentum of a price change, the volatility of prices, whether the prices are moving in a trend and volume related indicators. For example, the moving average indicator is a commonly used indicator for identifying price trends. There are now at least over hundreds of technical indicators in the market, some being more popular than others. Further, in each of the indicators, there are various parameters that can be set. One example of such parameter is the number of days for calculating the moving average. Different analysts will have a different preference for setting these parameters.
A user who wants to conduct technical analysis faces the situation of choosing from hundreds of technical indicators and setting the parameters of the different indicators. It is however comforting to know that most analysts only use a handful of the technical indicators and they have a set of parameters that they commonly use.
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