What is a "technical analysis" in business theory, and how does it allow stock traders to attempt to forecast security prices?

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justaguide | College Teacher | (Level 2) Distinguished Educator

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Stock traders earn profits by buying shares of corporations at a lower price and selling them at a higher price. Their success in doing this lies in being able to accurately forecast the change in price of the stock. There are many ways in which future stock price forecasts are made, these are broadly divided into two categories, fundamental analysis and technical analysis. Fundamental analysis is done by looking at factors that influence the profitability of a corporation; this includes operational efficiency, introduction of new products, change in demand of products by customers, state of the economy, action of competitors, etc.

Technical analysis on the other hand is based only on the study of historical price-volume charts of securities. Emotions have a large role to play in what stocks people buy, when they are bought and at what price they are bought. In the stock market, the valuation of corporations is seldom dictated by the inherent assets of the corporation. Technical analysts work with an assumption that stock prices follow patterns that repeat with time, making it possible to forecast the future value of a stock by studying its historical price charts. In addition, technical analysts look at the general trend of the stock market indices to extrapolate the results on the price of individual corporation's shares. The supply and demand of a stock changes with many factors not directly related to how the corporation is performing, by looking at these, technical analysts are able to make forecasts of how the stock price would change.

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Jamie Wheeler | College Teacher | eNotes Employee

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Let’s begin with a definition of “technical analysis” as it applies to business theory.  Technical analysis is the research that goes investments, assessing the supply and demand of investments based on the history of trade of a product as far as is price and volume. It is arguably the oldest type of security analysis; the first known analysis of this type is traced to 17th century Japan. The people who create technical analysis reports are typically called “chartists.” Chartists attempt to predict when there will be movement in stock or market value using computer programs that have analyzed past stock and market conditions; these reports also pinpoint trends that the chartists use to predict price fluctuations.  Chartists don’t really care why the fluctuations occur; they care primarily about identifying the ups-and-downs of pricing trends; some, but not all, chartists also track market cycles in the long term.  

Chartists think that market value is determined by supply and demand for stocks, which they believe is influenced by a variety of factors which must be continually weighed while also considering the sometimes irrational and frequently subjective. Chartist believe that wise investors will consider the history of trends and that these investors will profit when they can accurately determine when a trend first takes hold. Chartists provide two types of data to potential investors:  information about stock leaks into the market over the long-term and pointing out that time lags happen because investors at times disagree over the validity of information.  Price change happen gradually and being aware of these leaks and disagreements can benefit the investor by giving them time to take advantage of trends.

Chartists can help investors with their technical analysis by detect the onset of price changes from a new high or a new lower price.

There are many rules that chartists follow when compiling technical analysis reports that determine whether to buy, sell, or “sit” (do nothing) on an investments; among the most common rule are “contrary opinion rules” and rules that track market volume and pricing.  There are also rules that follow “sophisticated” investors.  While these rules are typically employed by chartists, they are open to interpretation and therefore different reports can lead to a variety of responses, depending on the analyst “crunching” the data.

Consider the first common rule, the ‘contrary opinion” rule. This rule argues that most investors are wrong about stock decisions the majority of the time, and many of the most egregious errors occur during market highs and lows.  Therefore,  if the majority of investors are acting “bearish,” a chartist would advise that it is a good time to buy, and vice versa.

Chartists also pay close attention to investors who have a record of savvy, or sophisticated, investments.  “Barron’s Confidence Index” is one way chartists track the movements of successful investors.  Barron’s Confidence Index compares the average yield on ten high-grand

In addition to contrary rules, some chartists follow the activities of investors that they consider smart and savvy. An indicator of such activities is Barron's confidence index, which is a bond index “comparing Barron's average yield on ten high-grade corporate bonds to the average yield of 40 average bonds on the Dow Jones.”

Other factors that influence the information in technical analysis reports complied by chartists include comparing stock prices and trading volume in order to guide purchasing decisions, taking into account the “Dow Theory.”  The Dow Theory argues that markets move in three ways: over major, long-term trends, intermediate trends, and short-run movements.  Chartists try to determine which of these three categories an investment is likely to fall in. They typically consider the “breadth of the market” to help guide their analytic decisions. They compare data on how many stocks have gone up in price, how many have gone down, and how many have remained unchanged, or stable. 

Source: Encyclopedia of Business, ©2000 Gale Cengage. All Rights Reserved

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