Technical analysis is a method of evaluating securities by analyzing statistics generated by market activity. If you have ever bought a stock, bond, or mutual fund only to watch it go down and then vowed to sell it once you “broke even,” you might benefit from learning more about how technical analysts evaluate the markets.
A technical analyst looks to take the emotion out of investing by applying rules that usually apply to almost every investment that fluctuates in price in a free market.
Technical analysis is based on three basic beliefs:
Price discounts everything. All fundamental, political and economic information available to the market is reflected in the price.
Price tends to move in trends. Charles Dow developed the Dow Theory based on his empirical observation of trends more than a century ago.
History tends to repeat itself. Basic human nature does not change and the market, reflecting the sum of all participants actions, behaves in identifiable patterns.
The foundation of all classical technical analysis is support and resistance: the behavior of buyers and sellers at key price levels. Trend theory is based on the performance of price at key support and resistance levels. Chart patterns similarly identify the behavior of buyers in relation to support and resistance.
Technical analysis is based on the assumption that historical performance or behavior is a strong indication of the future performance or behavior. The belief here is that securities move in predictable ways or trend and in the process they create patterns. All these will continue to occur unless there is something that will change this trend or pattern. And till that point of time, one can use the past actions for the prediction. The people who do such analysis are called technical analysts; they use sophisticated software to arrive at their observations and analysts look for similar patterns that have formed in the past, and will form trade ideas believing that price will act the same way that it did before. In many cases, there are traders who only use this for the purpose of their stock decisions.
Therefore, technical analysis uses a security’s past price movements to predict its future price movements. It focuses on the market prices themselves, rather than other factors that might affect them. It ignores the “value” of the stock and instead considers trends and patterns created by investors’ emotional responses to price movements.
It looks only at charts, as it believes that all of a company’s fundamentals are reflected in the stock price. It looks at models and trading rules based on price and volume transformations, such as the relative strength index, moving averages, regressions, inter-market and intra-market price correlations, business cycles, stock market cycles and chart patterns. Chart patterns are the most commonly studied, as they show variation in price movement. Common chart patterns include “head and shoulders,” which suggests that a security is about to move against the previous trend, “cup and handle,” which suggests that an upward trend has paused but will continue, and “double tops and bottoms,” which signal a trend reversal. Traders than calculate a security’s moving average (the average price over a set amount of time) to clean up the data and identify current trends, including whether a security is moving in an uptrend or a downtrend. These averages are also used to identify support and resistance levels. For example, if a stock has been falling, it may reverse direction once it hits the support of a major moving average. Traders also calculate indicators as a secondary measure to look at money flow, trends and momentum. A leading indicator predicts price movements, while a lagging indicator is a confirmation tool calculated after price movements happen.
Technical analysis assumes that market psychology influences trading in a way that enables predicting when a stock will rise or fall. For that reason, many technical analysts are also market timers, who believe that technical analysis can be applied just as easily to the market as a whole as to an individual stock.
The three main types of charts that a technical analyst uses are the line, the bar and the candlestick charts.
The line chart can give the reader a fairly good idea of where the price of an asset has traveled over a given time frame. Since the closing prices are often seen as the most important ones to keep track of, it is not difficult to see why line charts have become so popular.
The bar chart shows the opening and closing prices, as well as the highs and lows. The bottom of the vertical bar indicates the lowest traded price for that time period, while the top of the bar indicates the highest price paid. The vertical bar itself indicates the currency pair’s trading range as a whole. The horizontal hash on the left side of the bar is the opening price, and the right-side horizontal hash is the closing price.
The candlestick chart Candlestick bars still indicate the high-to-low range with a vertical line. However, the larger block (or body) in the middle indicates the range between the opening and closing prices. If the block in the middle is red, then the currency closed lower than it opened. If it is green it closed higher than it opened.
It can be used for short-term trading or long-term position buying. It is very complex and there are many indicators, systems, charts, and assumptions involved. We don’t recommend relying on technical analysis alone in making investment decisions.
1. Price trends
Is the price of the stock moving higher or lower? How long has it been doing so? Many chartists will only buy securities that are in uptrends. They may wait for a short-term downtrend to enter, but won’t even consider the stock if the longer-term trend is lower.
Volume can tell us how strong the prevailing trend might be. Decreasing volume can be a sign that the trend might be on the verge of a reversal.
3. Moving Averages
Adding moving average lines to a chart can help determine the overall trend direction. A moving average line simply plots the average price of a security over a set period of time. For example, the 50-day moving average indicates the average price over the past 50 days. Technicians like to buy when the moving average is trending upward and the price pulls back a touch to allow for a good “entry point” into the stock.
In a nutshell, fundamental analysis aims to determine intrinsic value by looking at the strength of the business, a financial analysis and the operating environment including macroeconomic events. Technical analysis analyzes past market performance by looking at the chart activity of price movements, volume, moving averages and the statistics of various outcomes. Fundamental analysis assumes the efficient market theory holds in the long run and attempts to take advantage of inefficiencies in the short run.
Technical analysis assumes fundamentals are already priced in and tries to find patterns that lead to outcomes with high probabilities of occurring. Technical analysis also captures the psychological aspects of the market in the review of past patterns, whereas fundamental analysis fails to factor in investor psychology but believes fundamentals will rule in the long term, so short-term psychological blips will correct themselves.
Fundamental analysis takes a long-term approach to analyzing the market, considering data over a number of years. So fundamental analysis is more commonly used by long-term investors as it helps them select assets that will increase in value over time.
Technical analysis takes a comparatively short-term approach to analyzing the market, and is used on a timeframe of weeks, days or even minutes. So it is more commonly used by day traders as it aims to select assets that can be sold to someone else for a higher price in the short term.
However, there is a perception that a mix of fundamentals and technical analysis could prove more beneficial to investors. Therefore, the best approach to investing likely involves some combination of fundamental and technical analysis.