worthy. Needless to say, insider trading is illegal in the equity markets. But the possibility will always exist that it can occur and in fact has on many occasions. Unfortunately, in unregulated over-the-counter (OTC) markets, nothing stops brokers from front running large client orders, which is just another form of insider trading.
Forecasting Stock Prices Using Technical Analysis
Technical analysis is essentially the identification and forecasting of potential market behavior based largely on the action and dynamics of the market itself. The action and dynamics of the market is best captured via price, volume, and open interest action. The charts provide a visual description of what has transpired in the markets and technical analysts use this past information to infer potential future price action, based on the assumption that price patterns tend to repeat or behave in a reasonably reliable and predictable manner. Let us turn our attention to some popular definitions of technical analysis.
The following definition of technical analysis tells us that charting is the main tool used to forecast potential future price action.
Technical analysis is the study of market action, primarily through the use of charts, for the purpose of forecasting future price trends.
The next definition of technical analysis tells us that the charting of past information is used to forecast future price action.
Technical analysis is the science of recording, usually in graphic form, the actual history of trading.. then deducing from that pictured history the probable future trend.
Notice that the last two definitions specifically refer to the forecasting of trend action.
It is interesting at this point to draw a parallel here with information used in fundamental analysis. Technical analysis is often criticized for the use of past information as a basis for forecasting future price action, relying on the notion that certain price behaviors tend to repeat. Unfortunately virtually all forms of forecasting are based on the use of prior or past information, which certainly includes statistical-, fundamental-, and behavior-based forecasting. Companies employ accounting data from the most recent and even past quarters as a basis for gauging the current value of a stock. In statistics, regression-line analysis requires the sampling of past data in order to predict probable future values. Even in behavioral finance, the quantitative measure of the market participant’s past actions form the basis for predicting future behavior.
The following definition of technical analysis tells us that it is the study of pure market action and not the fundamentals of the instrument itself.
It refers to the study of the action of the market itself as opposed to the study of the goods in which the market deals.
This next definition of technical analysis tells us that it is a form of art, and its purpose is to identify a trend reversal as early as possible.
The art of technical analysis, for it is an art, is to identify a trend reversal at a relatively early stage and ride on that trend until the weight of the evidence shows or proves that the trend has reversed.
The following definition is most relevant in the formulation of trading strategies. It reminds the market participants that nothing is certain and we must weigh our risk and returns.
Technical analysis deals in probabilities, never in certainties.
The next statement gives a behavioral reason as to why technical analysis works.
Technical analysis is based on the assumption that people will continue to make the same mistakes they have made in the past.
This definition by Pring stresses and underscores the point that there is a real reason and explanation as to why past price patterns tend to repeat. The tendency of price to repeat past patterns is mainly attributed to market participants repeating the same behavior. Although it is not impossible with sufficient and continuous conscious effort and strength of will, human beings rarely change their basic behavior, temperament, and deep-rooted biases, especially in relation to their emotional response to fear, greed, hope, anger, and regret when participating in the markets.
The following statement about technical analysis explains its effectiveness in timing early entries and exits.
Market price tends to lead the known fundamentals… Market price acts as a leading indicator of the fundamentals.
This definition by Murphy highlights a very important assumption in technical analysis, which is that price is a reflection of all known information acted upon in the markets. It is the sum of all market participants’ trading and investment actions and decisions, including current and future expectations of market action. It also reflects the overall psychology, biases, and beliefs of all market participants. Therefore, the technical analysts believe that the charts tell the whole story and that everything that can or is expected to impact price has already been discounted. This assumption forms the very basis of technical analysis, and without it, technical analysis would be rendered completely pointless.
Fundamental versus Technically Based Market Timing
Before proceeding any further, it is best to briefly explain the meaning of a few commonly used terms in trading and technical analysis:
• To go long means to buy to open a new position
• To liquidate means to sell to close a position previously held
• To go short means to sell to open a new position
• To cover means to buy to close a position previously shorted
Both fundamental and technically based market timing aim to satisfy the same basic principle of buying low and selling high. There are four basic scenarios where this may occur:
1. Long at a low price and liquidate at a higher price
2. Long at a relatively high price and liquidate at an even higher price
3. Short at a high price and cover at a lower price
4. Short at a relatively low price and cover at an even lower price
Listed below are the some of the strengths of each approach with respect to timing the markets.g
Technically Based Market Timing offers the ability to
• Provide precise entry and exit prices
• Provide the precise time of entry and exit
• Provide real-time bullish and bearish signals
• Provide real-time entry and exit price triggers
• Scale in and out based on significant price levels
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