At least in its modern version, technical analysis is generally seen as emanating from the “Dow Theory” established by Charles Dow at the start of the twentieth century. The core original ideas of technical analysis focused on the trending nature of prices, the idea of support and resistance and the concept of volume mirroring changes in price. Though we only touch on it here, the contribution of Charles Dow to modern-day technical analysis should not be underestimated. His focus on the basics of security price movement helped to give rise to a completely new method of analysing financial markets in general.
The basic premise behind this is that the price of a security represents a consensus. At the individual level, it is the price at which one person is willing to buy and another to sell. At the market level, it is the price at which the sum of market participants is willing to transact. The willingness to buy or sell depends on the price expectations of individual market participants. Because human expectations are relatively unpredictable, so the same must be said for their price expectations. If we were all totally logical and could separate our emotions from our investment decisions, one should assume that classic fundamental analysis would be a better predictor of future prices than it currently is. Prices would only reflect fundamental valuations. The fact that this is not the case suggests that other forces may be at work. Indeed, investor expectations also play a part, both at the individual level and also as a group.
Technical analysis is the process of analysing a currency or financial security’s historical price in an attempt to determine its future price direction. It is founded in the belief that there are consistent patterns within price action, which in turn have predictable results in terms of future price action. In contrast to economics, technical analysis requires that financial markets are not perfectly efficient, that there is no such thing as perfect knowledge or perfect information availability or usage, and also that in the absence of other information market participants will look to past price action as a determinant of future prices. For precisely this reason, the economics profession generally has dismissed technical analysis as irrational. However, just as we have already seen that financial markets are not perfectly efficient, so substantial research has shown conclusively both that technical analysis is widely practiced by market participants and perhaps more importantly that it has yielded substantially positive results. Traders who have used technical analysis have frequently made consistently high excess returns. Furthermore, in the context of the currency markets, technical analysis has a particularly good track record in predicting short-term exchange rate moves. How can this be so? Simply put, nature abhors a vacuum and thus in the vacuum left by classic economic analysis, in its inability to predict exchange rates over the short term, came technical analysis.