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The fundamental theory of technical analysis is based on three assumptions.
We would like to introduce technical analysis from a different view. Considering a fund manager or trader managing a big fund for clients or their employer. What would they do on a daily basis to decide what stocks to buy or what stocks to sell. Apart from analyzing the fundamental that will probably give them a view of the bigger picture, how would they decide when to jump in? and when to get out? What about when the fundamental economy is not going to change for the next six to twelve months. What're they going to do on a daily basis? Does that mean that the market is going to be very quiet?
It's very unlikely that their manager will let them sit back and relax for six months or a year time. They live on transactions. And many people, like brokers, also live on the commission of their transactions. It's different from personal investors that you don't have all these pressure. You just got to be in the market all the time.
Most of the daily transactions come from wholesale market. Retails are just the minority in the market. Remember, many investors nowadays are putting money into unit trust, mutual funds, etc. and that increases the wholesale proportion of daily transactions by a significant amount.
Working on the historical price seems to be inevitable. Some people find it hard to understand why the price movement in the future has something to do with the past. Let me put it this way, your action is based on the outcome of the analysis, fundamental or technical. Analyzing the balance sheet of a company is indeed studying the historical data. Your action has direct influence on the price movement especially if you're a big fund manager. In fact, we do have a causal effect here. This is all about statistics. Studying historical economic data and project the future growth and hence driving the price movement by putting money into the market is similar.
We emphasize chart pattern in technical analysis. People behave in a certain way when they react on certain news or information. You laugh when hear a funny joke. You cry when you hear a sad news. People did a statistics on historical price. Price movement can be categorized into few main categories that will be discussed in the next few tutorials. This is the whole idea of using technical analysis.
Assumption 3 in the beginning of this article is important. DON'T use technical analysis on an asset that doesn't have much liquidity or low volume of transaction. The best way to explain this is by statistical sense. You'll get a high variance from a small sample.
As a conclusion, we employ technical analysis because most market players are using it and, therefore, prices do move in patterns that we can use to predict future movement. Technical Analysis is one of the many analysis tools that can give you a bit more information about the market. It doesn't guarantee you a profit. It's not a substitution of other tools either. They should be compliment to one another. Some people have been arguing the reliability of technical analysis tool if everyone follows the same principle. Their main argument is why buying and selling opportunities would exist if they knew that the price is going to bounce from or to hit here or there. This is a pure theoretical argument. In the real world, individual has different risk tolerance. Some aggressive traders may go for the small price range right before a big reversal especially for professional traders. Some may believe a crucial chart point will be broken instead of acting as a solid wall. Or some big market makers may even sell heavily on a major support or buy significant amount right below a major resistance in order to squeeze stop loss orders. Remembering that, it's a zero-sum game. You can make money on either way. This lesson is about why we use technical analysis and we will talk about how to use it in the following tutorials.