Explanation of Technical Analysis

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    Trend-Following

    • Trend-following strategies are technical analysis studies designed to determine if the market is in a trend. A trend is a direction that the market follows in a continuous pattern over a period of time. One specific trend-following tool is a moving average crossover strategy. A moving average of market prices is the average of a specific financial instrument over a period of time. The average is considered moving when the latest price is added and the oldest price is dropped off the average calculation. A moving average crossover is when a shorter moving average crosses above the moving average for a longer period of time. For example, an upward trend could occur when a five-day moving average crosses above a 20-day moving average. Conversely, a downward trend could occur when a five-day moving average crosses below a 20-day moving average. Market participants use numerous averages when trying to create a comfort level that a trend is currently in place in a particular market.

    Mean Reversion

    • Mean reversion strategies are technical analysis studies that are meant to determine is a market is moving in a specific range. The study is trying to calculate how far a market can move in one direction, before it reverts back to a specific price average. One study used to determine this specific price action is a Bollinger Band strategy. This study examines prices over a specific period and calculates an average as well as a two-standard deviation point beyond the average, in an effort to create a range for the prices studied. When current prices move toward the two-standard deviation point, potentially they have moved to far in one direction or another. For example, a technician would consider buying a financial instrument if the prices fell to a level that was close to the two-standard deviation point below a specific moving average.

    Price Patterns

    • Pattern strategies are a third type of technical analysis. In these strategies, a technician will look for specific patterns to determine the direction of the market. One such example is trend-line formation within market prices. When a technician draws a trend line from one price to another, he/she is trying to create levels that might be support or resistance in the market. Support levels are prices that the market will not currently go below, and resistance levels are prices in which the market currently will not go above. When trend lines are broken, the market might continue in the direction in which the trend line was breached.

    Technical Analysis Periodicals

    • Numerous periodicals discuss the study of technical analysis. Two magazines that concentrate on this practice are "Technical Analysis of Stocks and Commodities" and "Futures Magazine."

    Conclusion

    • Technical analysis is a useful study to help market participants in an effort to create a specific trading strategy, or to assist in conjunction with other types of trading strategies. The study of technical analysis will not only help in strategy formation, but it will also allow the investor to have some insight into what other market participants might be considering.

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