Forecasting Future Financial Price Movements..

Like weather forecasting, technical analysis does not result in absolute predictions about the future. Instead, technical analysis can help investors anticipate what is "likely" to happen to prices over time. Technical analysis uses a wide variety of charts that show price over time.

Technical analysis is applicable to stocks, indices, commodities, futures or any tradable instrument where the price is influenced by the forces of supply and demand. Price data (or as John Murphy calls it, “market action”) refers to any combination of the open, high, low, close, volume, or open interest for a given security over a specific timeframe.

In order to be successful, technical analysis makes three key assumptions about the securities that are being analyzed:

High Liquidity: Liquidity is essentially volume. Heavily-traded stocks allow investors to trade quickly and easily, without dramatically changing the price of the stock. Thinly-traded stocks are more difficult to trade, because there aren't many buyers or sellers at any given time, so buyers and sellers may have to change their desired price considerably in order to make a trade. In addition, low liquidity stocks are often very low priced (sometimes less than a penny per share), which means that their prices can be more easily manipulated by individual investors. These outside forces acting on thinly-traded stocks make them unsuitable for technical analysis.

No Artificial Price Changes: Splits, dividends, and distributions are the most common “culprits” for artificial price changes. Though there is no difference in the value of the investment, artificial price changes can dramatically affect the price chart and make technical analysis difficult to apply. This kind of price influence from outside sources can be easily addressed by adjusting the historical data prior to the price change.

No Extreme News: Technical analysis cannot predict extreme events, including business events such as a company's CEO dying unexpectedly, and political events such as a terrorist act. When the forces of “extreme news” are influencing the price, technicians have to wait patiently until the chart settles down and starts to reflect the “new normal” that results from such news.

It is important to determine whether or not a security meets these three requirements before applying technical analysis. That's not to say that analysis of any stock whose price is influenced by one of these outside forces is useless, but it will affect the accuracy of that analysis.

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