Many investors are skeptical about the usefulness of technical analysis. It is easy to understand why such sentiments exist. After all, technical analysis is about predicting share price using share price information alone. To most investors who study the fundamentals of companies, technical analysis sounds like nothing more than tea leaves reading.

So why does technical analysis works? In this article, we will investigate what information is contained in a share price and provide an explanation.

Cause and effect

Cause and effect is the underlying principle that governs all share price movements. In essence, the company's fundamentals and market conditions are the causes, whereas the share price movement is the effect. When a company announces unexpected good news, share price goes up. In this case, the unexpected good news is the cause and share price appreciation is the effect. Adopting this view of cause and effect allows us to put things into perspective: fundamental analysis studies the causes, technical analysis studies the effect.

Why not just use fundamental analysis to analyze the causes?

At this point we need to ask ourselves an important question: since fundamental and market conditions are the causes while share price is the effect, and causes precede effect, why not just focus on analyzing the causes? At first glance, this seems like a good idea. In fact, this is generally advocated by hardcore fans of the fundamental analysis camp. However, there are some major difficulties with fundamental analysis.

1. Firstly, there are too many factors to be considered. At the micro level we have profit and loss, balance sheet, cashflow, company's strategy, management quality, competitors, etc. At the macro level we have industry condition, economical condition, interest rate, inflation, cost of raw material, market sentiments, etc. Most, if not all, fundamentalists consider only a subset of all possible causes and discount the rest as negligible. In addition, not all causes are publicly known and they can remain unknown for a long period of time, but the effect may already have found its way into the share price.
2. Secondly, we need to draw an intuitive relationship between cause and effect by translating what we know about the causes into probable effect.

Why use technical analysis to analyze the effect?

Technical analysis, on the other hand, analyzes only 1 element, which is the share price. Remember that share price is the effect and effect is the aggregate outcome of all causes. This implies that all available information is already factored into the share price movement. As an analogy, consider a mechanical system with one end of a spring attached to the roof and the other end attached to a weight. The weight is pulled downwards and then released. Assuming you entered the room with this setup after the weight was released. By observing its oscillation, you will be able to draw useful insights on its behaviour and are capable of predicting its next position. The system behaviour contains all causes - the initial downward pull, the weight's mass, gravity and the stiffness of the spring- that are unknown to you, but you are still able to make good prediction by observing the effect.

Compare this with the fundamental approach, we can easily see the benefits of technical analysis.

1. Firstly, technical analysis deals only with 1 factor which contains information of all causes. This is unlike fundamental analysis which has a huge array of known and unknown causes.
2. Secondly, technical analysis studies price and make probabilistic projections on share price directly. This is in stark contrast to fundamental analysis that requires the translation of causes into probable effect.

Technical analysis is, however, not without pitfalls. Among other things, we should always remember that effect can never precede causes. In other words, we can never make any prediction before some symptoms had already developed. In addition, we must also be mindful that although the problem domain is collapsed to 1 factor (share price), there are in fact multiple factors (causes) affecting it and these factors are not constant. In other words, a lot have been wrapped up in our simplistic price-only view and we do not know what lies within, hence our prediction is nothing more than a best guess and it is very important to have a strict risk management strategy.

In essence, technical analysis is not tea leaves reading but a study of probability. If certain share price pattern is observed, technical analysis may deduce that the probability of it going up is higher than that of going lower. However, technical analysis is not a holy grail to easy profit. To achieve the level of skills so that we are more often right than wrong will take lots of studies, practices and hard work. There is no free lunch.