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#1 Posted : Thursday, April 24, 2008 10:37:18 AM(UTC)

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Technical analysis

Should I buy today? What will prices be tomorrow,
next week, or next year? Wouldn't investing be easy if we knew the
answers to these seemingly simple questions? Alas, if you are reading
this book in the hope that technical analysis has the answers to these
questions, I'm afraid I have to disappoint you early--it doesn't.
However, if you are reading this book with the hope that technical analysis will improve your investing, I have good news--it will!

Some history

The term "technical analysis" is a complicated
sounding name for a very basic approach to investing. Simply put,
technical analysis is the study of prices, with charts being the primary tool.

The roots of modern-day technical analysis stem
from the Dow Theory, developed around 1900 by Charles Dow. Stemming
either directly or indirectly from the Dow Theory, these roots include
such principles as the trending nature of prices, prices discounting
all known information, confirmation and divergence, volume mirroring
changes in price, and support/resistance. And of course, the widely
followed Dow Jones Industrial Average is a direct offspring of the Dow Theory.

Charles Dow's contribution to modern-day technical
analysis cannot be understated. His focus on the basics of security
price movement gave rise to a completely new method of analyzing the markets.

The human element

The price of a security represents a consensus. It
is the price at which one person agrees to buy and another agrees to
sell. The price at which an investor is willing to buy or sell depends
primarily on his expectations. If he expects the security's price to
rise, he will buy it; if the investor expects the price to fall, he
will sell it. These simple statements are the cause of a major
challenge in forecasting security prices, because they refer to human
expectations. As we all know firsthand, humans are not easily
quantifiable nor predictable. This fact alone will keep any mechanical trading system from working consistently.

Because humans are involved, I am sure that much of
the world's investment decisions are based on irrelevant criteria. Our
relationships with our family, our neighbors, our employer, the
traffic, our income, and our previous success and failures, all influence our confidence, expectations, and decisions.

Security prices are determined by money managers
and home managers, students and strikers, doctors and dog catchers,
lawyers and landscapers, and the wealthy and the wanting. This breadth
of market participants guarantees an element of unpredictability and excitement.

Fundamental analysis

If we were all totally logical and could separate
our emotions from our investment decisions, then, fundamental analysis
the determination of price based on future earnings, would work
magnificently. And since we would all have the same completely logical
expectations, prices would only change when quarterly reports or
relevant news was released. Investors would seek "overlooked" fundamental data in an effort to find undervalued securities.

The hotly debated "efficient market theory" states
that security prices represent everything that is known about the
security at a given moment. This theory concludes that it is impossible
to forecast prices, since prices already reflect everything that is currently known about the security.

The future can be found in the past

If prices are based on investor expectations, then
knowing what a security should sell for (i.e., fundamental analysis)
becomes less important than knowing what other investors expect it to
sell for. That's not to say that knowing what a security should sell
for isn't important--it is. But there is usually a fairly strong
consensus of a stock's future earnings that the average investor cannot disprove.

"I believe the future is only the past again, entered through another gate."
- Sir Arthur Wing Pinero, 1893

Technical analysis is the process of analyzing a
security's historical prices in an effort to determine probable future
prices. This is done by comparing current price action (i.e., current
expectations) with comparable historical price action to predict a
reasonable outcome. The devout technician might define this process as
the fact that history repeats itself while others would suffice to say that we should learn from the past.

The roulette wheel

In my experience, only a minority of technicians
can consistently and accurately determine future prices. However, even
if you are unable to accurately forecast prices, technical analysis can be used to consistently reduce your risks and improve your profits.

The best analogy I can find on how technical
analysis can improve your investing is a roulette wheel. I use this
analogy with reservation, as gamblers have very little control when
compared to investors (although considering the actions of many investors, gambling may be a very appropriate analogy).

"There are two times in a man's life when he should not speculate: when he can't afford it, and when he can."
- Mark Twain, 1897

A casino makes money on a roulette wheel, not by
knowing what number will come up next, but by slightly improving their odds with the addition of a "0" and "00."

Similarly, when an investor purchases a security,
he doesn't know that its price will rise. But if he buys a stock when
it is in a rising trend, after a minor sell off, and when interest
rates are falling, he will have improved his odds of making a profit.
That's not gambling--it's intelligence. Yet many investors buy securities without attempting to control the odds.

Contrary to popular belief, you do not need to know
what a security's price will be in the future to make money. Your goal
should simply be to improve the odds of making profitable trades. Even
if your analysis is as simple as determining the long-, intermediate-,
and short-term trends of the security, you will have gained an edge that you would not have without technical analysis.

Consider the chart of Merck in Figure 1 where the
trend is obviously down and there is no sign of a reversal. While the
company may have great earnings prospects and fundamentals, it just
doesn't make sense to buy the security until there is some technical evidence in the price that this trend is changing.

Figure 1

Automated trading

If we accept the fact that human emotions and
expectations play a role in security pricing, we should also admit that
our emotions play a role in our decision making. Many investors try to
remove their emotions from their investing by using computers to make
decisions for them. The concept of a "HAL," the intelligent computer in the movie 2001, is appealing.

Mechanical trading systems can help us remove our
emotions from our decisions. Computer testing is also useful to
determine what has happened historically under various conditions and
to help us optimize our trading techniques. Yet since we are analyzing
a less than logical subject (human emotions and expectations), we must
be careful that our mechanical systems don't mislead us into thinking that we are analyzing a logical entity.

That is not to say that computers aren't wonderful
technical analysis tools--they are indispensable. In my totally biased
opinion, technical analysis software has done more to level the playing
field for the average investor than any other non-regulatory event. But
as a provider of technical analysis tools, I caution you not to let the
software lull you into believing markets are as logical and predictable as the computer you use to analyze them.

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