Introduction

The US stock market began in 1792 on the streets of New York City as a way for businesses to connect with individual investors to provide capital for business ventures. What began under a Buttonwood tree more than 200 years ago has become the foundational infrastructure of capitalism across the United States and around the world. This magical “market” where fortunes can be made or lost in a matter of minutes, or hours, has been the bane of many a man in search of wealth. Times of boom have created envy of those who are successful, and times of bust have devastated those same successful people as their egos fill with humility, full of the realization they are not financial gods but merely men participating in the economic cycles of the earth.

And yet despite the bust cycles, the favorable memories of the booms have allowed society to forget the woes and press forward in favor of capitalism. The opportunity to place one’s financial resources, or capital, on the line with the hopes of riding on another’s creative business dream to financial success is not just the backbone of the American way but is in fact it the lifeblood of the American economy. Along the way, the drive to create greater wealth has simply driven the investors, or capitalists, to create ways of predicting the direction of their trades with greater accuracy.

These means of predicting future market behavior varies as wide as the very people participating in the trading of the market. Some study the forces within a company that may affect the price action of the stock, while others study the forces outside a company. Some have attempted to apply the study of astrology and the reading of stars to the price performance of the stock. And most have found themselves miraculously religious when a trade has moved against them as they pray desperately, to whatever god may be listening, to turn this trade around and return their capital.

And yet through all of this, only one study has truly captured the essence of the factors inherent in the price movements of a stock. The amazing thing about this study is it applies not only to stock trading but also to any other form of free or open market equity exchange. In its most simple form it can be summed up as this: the study of human behavior. We call the study “technical analysis,” and it is only through technical analysis that the everyday price swings of a market can be measured, analyzed, and used to predict future price swings. Yet the study in and of itself says nothing of the actual price of a given equity.

So what is this mysterious study referred to as technical analysis? As already mentioned, technical analysis is at the core a study in human behavior. Since people are the ones who place money into and out of an equity as a means of lending capital, it makes sense to think that studying the past behavior of those people would yield believable results in predicting their future behavior. And since it is the behavior of those people trading a security that affects the price action, technical analysis assumes we can predict the future price action of a stock based on the prediction of the behavior of those very people who trade the stock.

Does it sound complicated? Maybe a little scary? It’s not. On the contrary—it’s actually quite predictable! How can that be? Well, people are creatures of habit. Not only do people tend to repeat their behavior over and over, but all people are at least partially controlled by emotion. And emotion, when understood, can give us the keys to market behavior.

What types of emotion are we talking about? When it comes to the capital markets, the two key emotions are fear and greed. These two emotions lead to two correlating states of mind: optimism and pessimism. When one is afraid his investment may lose value, he tends to become very pessimistic and sell his holdings. When the same person believes the investment may rise in value, he tends to be greedy, wanting as much of that gain as possible. Thus, his state of mind becomes very optimistic as he see visions of grandeur while imagining his bank account growing seemingly out of thin air.

In theory, these two emotions and the two states of mind that accompany them are the foundation of all technical analysis. In practice, we analyze that fear and greed (also called sentiment) through the price action of a stock (or any other type of investment equity). It is the study of that price action that allows a technical analyst to predict the future price action of a trade. And knowing the likely future price action allows the investor to make money with confidence.


A Word About Fundamental Analysis

The primary opposing view to technical analysis is known as fundamental analysis. Fundamental analysts makes all of their investment decisions based on the health of a company—the company’s underlying strength. For example, fundamental analysts will reference the price per share as compared to the amount of money the company is earning. Or they may analyze the qualifications of the people running the company. There are several factors that can go into fundamental analysis that are beyond the scope of our time together. Suffice it to say, fundamental analysis is a very logical form of analysis from the purely analytical perspective. If a company has good health, the price should perform well. Unfortunately, fundamental analysis does not account for the single most driving factor in price performance—the sentiment (emotion) of the people actually trading the stock.

I have a saying I often share with my students that goes like this: “As far as the public is concerned, the fundamentals of a company only change four times a year on earnings day, so why is it that the price of a stock changes every day?” If you’re new to investing, earnings day is the day when a company announces how well they have been doing and if they are on track with their own financial projections. The SEC (Securities and Exchange Commission) requires a company to report earnings once a quarter. Thus, four times a year we have an update to the public.

So the question is, “If the fundamental data of a stock does not change, then what causes the daily price change of a stock?” I will illustrate this point by recounting a conversation I had with a student. We were discussing the company Auto Zone. During the crash of 2008 and into 2009, Auto Zone defied the market. While most companies were losing value, the stock of Auto Zone more than doubled in value! The entire market was moving lower, and yet this company had extraordinary results. How? Why? The student gave this explanation: “Because the economy is bad, people are more likely to fix old cars rather than buy new ones, thus a company that sells auto parts is likely to see a spike in sales.”

An astute observation to say the least—one that is very logical and steeped in the typical assumptions of a fundamental analyst. Yet there is something key to his response that answers my very initial question. The key word is “likely.” “Because the economy is bad, people are more likely to fix old cars rather than buy new ones, thus a company that sells auto parts is likely to see a spike in sales.” Likelihood is an assumption, not a reflection of a change in fundamental data. It is an assumption, or shall we say a speculation, that the fundamental data will change in the future.

And this speculation is the key to market behavior. The reason a stock moves on a daily basis despite the reality that fundamental data has not changed one bit is because of the masses who speculate a future change in the fundamental data. The speculation causes weekly, daily, and even hourly changes in the price of a given stock.

This leads us to the next question: Who are the speculators? The answer is people. You and I, investment firms, and hedge fund managers. Whether it be an individual investing for personal retirement or a fund manager investing other people’s money because it’s their job, at the end of the speculation chain is nothing more and nothing less than a person. A person who is ruled by human emotion. And as such, if we are to predict the most likely behavior of a stock’s price, we must look to the source of the movement of that price—people.

Technical analysis is the only method of analyzing a stock, or any financial equity, that takes into account the emotional behavior of the people trading that stock. And it is for this very reason that technical analysis is able to predict market reversals and to help the astute investor know how to fine tune an entry into a position. It also allows investors to know when to close a position to avoid one of those nasty market corrections—the ones that fundamental analysts say are “just part of the market.”

To learn more about how technical analysis works, read Part 2 of this series. You’ll learn about price charts, support & resistance, and more!

How to Learn More

If what you have just read makes sense to you and you’d like to learn more, the best place to start is Trade Smart University’s free workshop called the Foundations of Stocks and Options. You don't want to miss this free online workshop!

Jeremy Whaley is co-founder of Trade Smart University, an education company dedicated to helping everyday people learn to trade the stock market for consistent profits. If you would like to learn how to trade your own money for steady profits, visit www.TradeSmartU.com and experience affordable, accessible stock market education.