A History and Brief Overview of Technical Analysis

Manogane Sydwell

Feb 26, 20213 min read

Introduction and History

Nowadays because of the prevalence of websites like investing.com and morningstar.com, in addition to the support of academic and industry institutions, fundamental analysis is the mostly accepted and widely used form of security valuation. Fundamental analysis is made up of variety of components, including legal documents and economic data amongst others. The most important piece in this type of analysis would be the financial statements, and not until 1934 was this information available to the public. Prior to the Securities and Exchange Act, technical analysis was the most common method used to value companies, amongst a plethora of other securities.

Technical analysis was first used in Japan in the 1700s, before the Meiji Restoration during which Japan did not trade with foreign nations. Candlestick Chart Patterns with names like "advancing three soldiers", "counter attack lines" and "night and morning attacks" indicate that technical analysis began at a time when the military was in control in the region under consideration. In Edo-period Japan, traders applied technical analysis as they sought to profit from Osaka's rice futures market(insert relevant link). Probably the world's first behavioral economist, Munehisa Homma attributed trends and reversals to the human emotions exhibited in market behavior and subsequently wrote about this in some of his writings like The Three Monkey Record of Money.

Even though technical analysis has received contributions from a variety of individuals from all over the globe, the above paragraph aims to point out that technical analysis has its foundations in the study of market psychology. For a much more elaborate and comprehensive history on technical analysis, I recommend you check the following article out from Winton.com.

Concept underlying Technical Analysis

Technical analysis is the study of investor psychology. Prices in any freely traded market are set by human beings or their algorithmic systems, and the price of the underlying in question is equal to the balance between supply and demand at any given time. Human behavior is regularly sporadic and driven by emotion in many facets of life; contrary to the Rational Expectations Hypothesis, it is unreasonable to think that investing is the one exception where people behave rationally.

Irrespective of whether the type of analysis used is fundamental or technical, the chosen method will have a subjective element when finally applied to the security in question. One of the key tenets of technical analysis is the use of indicators. Even though the calculation of these indicators entails the use of formulas, the interpretation that results from such a calculation is something that is subjective.

The same situation applies to fundamental analysis, where formulas will be used to calculate ratios like Return on Equity, but the evaluation of those results entails taking a subjective stance in reference to the security in question. To make matters even worse, the construction of financial statements has a subjective side to it as well, considering the variety of depreciation methods available, in addition to the various ways in which intangible assets are treated, which could all result in different net profit figures.

This is where a systems approach triumphs over the two methods given above. Not only does it enable the testing of strategies on empirical and live data, but these strategies are also automated. This significantly reduces human bias, which would be evident if trades and other facets like portfolio rebalancing were to be automated.

Conclusion

The fact that technical analysis has been in use for 300 years or so shows that this form of examination does work, probably even more so when combined with sentiment analysis from a website like stocktwits.com. Having gone through the history of technical analysis in this article, I will provide an implementation of technical analysis on a security using his form of examination in a related article. Complement this article with the following video.