What Is Technical Analysis?
Technical analysis is a popular trading method that evaluates trading activity data, focusing on price and volume, to find investment opportunities and determine optimal trade entry and exit points. It contrasts with fundamental analysis, which assesses a security’s value based on financial data like earnings and sales.
Key Takeaways
- Technical analysis evaluates price trends and volume patterns to identify potential investments and trading opportunities.
- It contrasts with fundamental analysis, as it relies on past price movements rather than financial metrics to predict future trends.
- Analysts use various tools like chart patterns, momentum indicators, and moving averages to forecast price changes.
- Critics argue that technical analysis can be a self-fulfilling prophecy and emphasize that prices may follow a random walk.
- Top online brokerage firms can offer their traders a premium service by providing them with extensive trading tools, such as indicators, interactive charts that stream live data, and a plethora of research amenities, for little to no extra cost.
Deep Dive Into Technical Analysis
Technical analysis is used to scrutinize the ways supply and demand for a security affect changes in price, volume, and implied volatility. It assumes that past trading activity and price changes of a security can be valuable indicators of the security’s future price movements when paired with appropriate investing or trading rules.
Technical analysis’s various charting tools are often used to generate short-term trading signals. They also help assess a security’s strength or weakness compared to the broader market or specific sectors. Analysts use this information to improve overall valuation estimates.
Practical Applications of Technical Analysis
Professional analysts often use technical analysis in conjunction with other forms of research. Retail traders often rely on price charts and similar stats to make decisions. But practicing equity analysts rarely limit their research to fundamental or technical analysis alone.
You can apply technical analysis to any security with historical trading data. This includes stocks, derivatives, commodities, fixed-income securities, currencies, and more. Technical analysis is common in commodities and forex markets where traders focus on short-term price changes.
Technical analysis attempts to forecast the price movement of virtually any tradable instrument that is generally subject to forces of supply and demand. Some view technical analysis as simply the supply and demand forces reflected by the market price movements of a security.
Technical analysis most commonly applies to price changes, but some analysts track numbers other than just price, such as trading volume or open interest figures.
Key Technical Indicators for Investors
Researchers have developed hundreds of patterns and signals throughout the years to support technical analysis trading. Technical analysts have also developed numerous types of trading systems to help them forecast and trade on price movements.
Some indicators identify current market trends, including support and resistance areas. Others assess a trend’s strength and whether it will continue. Commonly used technical indicators and charting patterns include trendlines, channels, moving averages, and momentum indicators.
In general, technical analysts look at the following broad types of indicators:
- Price trends
- Chart patterns
- Volume and momentum indicators
- Oscillators
- Moving averages
- Support and resistance levels
Core Principles of Technical Analysis
Technical analysis attempts to decipher the market sentiment behind price trends by looking for price patterns and trends. Charles Dow released a series of editorials discussing technical analysis theory. He had two basic assumptions that continue to form the framework for technical analysis trading.
- Markets are efficient with values that represent factors that influence a security’s price.
- Even random market price movements appear to move in identifiable patterns and trends that tend to repeat over time.
Comparing Fundamental and Technical Analysis
Fundamental analysis and technical analysis, the two major schools of thought when it comes to approaching the markets, are at opposite ends of the spectrum. Both methods are used to research and forecast future trends in stock prices, and like any investment strategy or philosophy, both have their pros and cons.
Fundamental Analysis
Fundamental analysis is a method of evaluating securities by attempting to measure the intrinsic value of a stock. Fundamental analysts study everything from the overall economy and industry conditions to the financial condition and management of companies. Earnings, expenses, assets, and liabilities are all important characteristics of fundamental analysis that help analysts determine the fair value of a business.
Technical Analysis
Technical analysis differs from fundamental analysis in that the stock’s price and volume are the only inputs. The main belief is that all known fundamentals are already reflected in the price, so they aren’t closely examined. Technical analysts do not attempt to measure a security’s intrinsic value, but instead, use stock charts to identify patterns and trends that suggest how a stock’s price will move in the future.
Challenges and Limitations of Technical Analysis
First challenge and limitation: For some analysts and academic researchers, the EMH demonstrates why no actionable information is contained in historical price and volume data. However, by the same reasoning, business fundamentals should not provide actionable information. These points of view are known as the weak form and semi-strong form of the EMH.
Second challenge and limitation: Another criticism of technical analysis is that history does not repeat itself exactly, so price pattern studies are of dubious importance and can be ignored. Prices seem to be better modeled as random walks.
Third challenge and limitation: The last criticism of technical analysis is that it works in some cases, but only because it constitutes a self-fulfilling prophecy. For example, many technical traders will place a stop-loss order below a company’s 200-day moving average.
If a large number of traders have done so and the stock reaches this price, there will be many sell orders, pushing the stock price down, confirming the anticipated movement.
Then, other traders will see the price decrease and sell their positions, reinforcing the strength of the trend. This short-term selling pressure can be considered self-fulfilling, but it will have little bearing on where the asset’s price will be weeks or months from now.
In sum, if enough people use the same signals, they could cause the movement foretold by the signal. However, this sole group of traders cannot drive the price over the long run.
How Can I Learn Technical Analysis?
Your first step is to learn about investing, stocks, markets, and financials. This can be done through books, online courses and materials, and in-person classes. Once you understand the basics, you can start studying technical analysis.