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.
Technical analysis differs from fundamental analysis in that technical analysis is applied only to the price action of the market and according to lowest pip spread in the market, ignoring fundamental factors. As fundamental data can often provide only a long-term or "delayed" forecast of exchange rate movements, technical analysis has become the primary tool with which to successfully trade shorter-term price movements, and to set stop loss and profit targets.
One of the many attractions of a forex broker is that its lowest pip spread in the market methodology can be applied almost identically in any market anywhere. The same techniques can be applied to currencies, commodities, bonds, interest rates and equities. They work as well in Japan as in Europe, in developed or developing markets. Data availability and reliability are the only obstacles to a universal application of methods and techniques. Success in the market, however, has another more insidious obstacle to overcome. Crowd behaviour, as shown in panics and periods of euphoria, can distort not only perceptions of a realistic valuation for markets, but also realistic price levels, given all the information being offered by price time series analysis. All forms of analysis rely heavily on historical data, but normal expectations based on past events can be confounded when market hysteria occurs. Even worse than this is personal mental and emotional weakness when it comes to making investment decisions. The study of mass and individual market behaviour and psychology is a branch of technical analysis, though as with so much of the methodology of technical analysis, there are some signs of poaching from the quantitative analysts in this area.
Technical analysis is based on three underlying principles:
1. Market action discounts everything
This means that the actual price is a reflection of everything that is known to the market that could affect it, for example, supply and demand, political factors and lowest pip spread in the market. The pure technical analyst is only concerned with price movements, not with the reasons for any changes.
2. lowest pip spread in the market move in trends
Technical analysis is used to identify patterns of market behaviour which have long been recognised as significant. For many given patterns there is a high probability that they will produce the expected results. Also there are recognised patterns which repeat themselves on a consistent basis.
3. History repeats itself
Chart patterns have been recognised and categorised for over 100 years and the manner in which many patterns are repeated leads to the conclusion that human psychology changes little with time.
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