Technical analysis is a type of trading practice. Analysts use it to evaluate investments and identify trading opportunities by dissecting statistical trends that are collected from trading activity. These activities include price movement and volume.
Contrary to what fundamental analysts do, which is attempt to evaluate a security’s inherent value, technical analysts focus primarily on patterns of price movements, trading signals, and an array of other analytical charting tools to grade and classify both the strength and the weakness of a security system. They closely analyze investments based on previous market prices and technical indicators. According to their close and careful interpretations of past trading patterns, these analysts attempt to perceive the balance. Their chief goal is predicting any future price movements.
Technical analysts have gradually developed an extensive toolbox of methods and indicators pertaining to analyses. For the most part, the use of a single technical indicator (mathematical calculations that are based on the price, volume, or open interest of either a security or contract) does not wholly provide the right amount of information in order to make a trading decision. That is why technicians employ several indicators to validate a hypothesis before inevitably taking action.
Investopedia editor, James Chen, writes that:
“There is no broad consensus on the best method of identifying future price movements, so most technicians gradually develop their own set of trading rules based on their knowledge and experience. Technical analysts can work in either buy side or sell side firms. As of 2018, technical analysts earn an average income of $70,500.”
What securities does technical analysis cover?
Technical analysis as a whole can be utilized on pretty much any security system with historical trading data. This includes:
- Futures (financial contracts that require either the buyer to purchase an asset or the seller to sell an asset)
- Commodities (basic goods in economics that are interchangeable with various other assets of a similar type)
- Fixed-income, currencies
- And a variety of other types of securities
To sum up this section defining analysis, it is a trading discipline that is carried out by technical analysts. It may essentially be contrasted with fundamental analysis, which places its focus on a company’s financials as opposed to historical price patterns or past stock trends.
Breaking it down
To understand the basics of technical analysis, we first need to learn about how it came to be.
This type of analysis was first introduced in the late 1800s by Charles Dow with the Dow Theory. There are a few noteworthy researchers such as Robert Rhea, Edson Gould, William P. Hamilton, and John Magee who all assisted in contributing towards concepts surrounding the Dow Theory and forming its basis.
Fast forward to modern day and we see that technical analysis has evolved. Now it includes hundreds of patterns and signals have actively been developing throughout the years of research.
Technical analysts are of the belief that past trading activity and changes to the price of a security can be incredibly valuable indicators of the security’s future movements of price.
They will usually employ the use of technical analysis separate from other research efforts or in combination with a number of concepts that are of essential value considerations. That being said, most of their convictions are often based primarily on the statistical charts belonging to a security.
The Market Technicians Association (MTA) is regarded as being one of the most popular groups that actively support technical analysts in their investments with the Chartered Market Technicians (CMT). The CMT designation is a well-known certification for many of the more advanced technical analysts.
Two fundamental methods
There are two fundamental methods that are used to examine securities and come up with investment decisions: fundamental analysis and technical analysis.
As previously touched upon, fundamental analysis involves analyzing a company’s financial statements to determine the fair value of the business.
On the other hand, technical analysis assumes that a security’s price already reflects all of the information that’s publicly available. It instead narrows in on the statistical analysis of price movements. Technical analysis typically attempts to properly understand the market sentiment behind price trends by way of looking for patterns and trends. This is opposed to analyzing a security’s most fundamental attributes.
Charles Dow released a series of editorials that discussed technical analysis theory. His collection of writings included two basic assumptions that have proceeded to create the framework for technical analysis trading:
- Markets are generally efficient with values representing factors that have an influence on a security’s price.
- Market price movements are not entirely random. They move in identifiable patterns and trends that have a tendency to repeat over time.
Efficient Market Hypothesis
The Efficient Market Hypothesis (EMH) basically means that the market price of a security at any given point in time accurately illustrates all of the available information. Thus it represents the true fair value of the security.
This common assumption is based on the idea that market price reflects the sum knowledge of all market participants. While most believe this to be true, news stories or announcements involving a security can easily come into play. These kinds of events may have varied between short-term and/or long-term influence on a security’s price. Technical analysis will only work if markets are efficient at a weak level.
The second of the basic assumptions that underlie technical analysis – the notion that price changes are not random – leads to the common belief of technical analysts that market trends both short-term and long-term can be identified. Therefore, it allows market traders to profit from investing based on trend analysis.
Nowadays, technical analysis is mostly based on three main assumptions:
The market discounts everything
A good number of experts criticize technical analysis because it only considers price movements and ignores the more fundamental factors. Technical analysts think that everything from a company’s essentials to broad market factors to ‘market psychology’ (the prevalent sentiment of financial market participants at any point in time) is already priced into the stock.
This ultimately removes the need to take the factors separately into consideration before making an investment decision. The only thing that remains is the analysis of price movements. This is what technical analysts view as the product of supply and demand for a particular stock within the market.
Price moves in trends
Technical analysts typically believe that prices will move in short-term, medium-term, and long-term trends. So basically, a stock price is usually more likely to continue a past trend than it is to move erratically. Most of the technical trading strategies are based on this particular assumption.
History is prone to repeating itself
Technical analysts believe that history will continue to repeat itself. The repetitive nature of price movements is relevant to the previously mentioned market psychology. This tends to be incredibly predictable based on emotions such as fear or excitement.
Technical analysis utilizes chart patterns as a way to analyze these emotions objectively and study consecutive market movements to better understand trends. While numerous forms of technical analysis have been available for more than 100 years, they are still generally believed to be relevant. This is mainly due to them illustrating patterns in price movements that tend to repeat themselves.
How to Use Technical Analysis
How technical analysis is somthing that tries to predict the price movement of virtually any tradable instrument. Such an instrument is often subject to the focus of supply and demand, which includes stocks, bonds, futures, and currency pairs. As a matter of fact, some see technical analysis as nothing more than the study of supply and demand forces as reflected in the movements of the market price of a security.
Technical analysis frequently applies to price changes, however, some analysts track numbers other than just price, such as trading volume or even open interest figures.
All across the industry, there exists hundreds of various patterns and signals that have been developed by researchers in order to support technical analysis trading. In addition, technical analysts have developed numerous types of trading systems to assist them in forecasting and trading on price movements.
Focus of indicators
Some indicators focus primarily on pinpointing and identifying the current market trend, including support and areas of resistance. Whereas others focus mostly on determining the strength of a trend and the prospect of its continuation. Some of the more commonly used technical indicators and charting patterns include:
- Moving averages
- Indicators of momentum.
Overall, technical analysts look at the following broad variations of indicators:
- Price trends
- Chart patterns
- Volume and momentum indicators
- Oscillators (typically banded between two extreme values and then constructs a trend indicator with the results)
- Moving averages (assist in isolating the trend in a security or market, or the lack of one, and can also signal whenever a trend may be reversing)
- Support and resistance levels
What’s the difference between this and ‘fundamental’?
You might be wondering what exactly sets fundamental analysis apart from technical analysis. They are on opposite ends of the spectrum when it comes to markets. But what they have in common is that both of them help analysts research and forecast future trends in stock prices. Similar to other investment strategies or philosophies, they both have their advocates and opponents.
Fundamental analysis is a method of assessing securities by aiming to measure the intrinsic value of a stock. Fundamental analysts study pretty much everything from the overall economy and industry conditions to the financial condition and the management of companies. The most crucial characteristics to these specific analysts are earnings, expenses, assets
Technical analysis is distinct from fundamental analysis due to the fact that the stock’s price and volume are the only inputs. The core assumption is that all of the most well-known fundamentals factor into the price. So there is no need to pay close attention to them. Technical analysts usually do not attempt to measure a security’s intrinsic value. Alternatively, they utilize stock charts as a means to identify patterns and trends that indicate what a stock will do in the future.
Criticisms & Limitations
As one might expect, there is a major hurdle regarding the legitimacy of technical analysis. That is the economic principle of the Efficient Market Hypothesis. According to it, market prices reflect all current and past information already. So there is no real way to take advantage of patterns or mispricings to earn extra profits or alpha.
Economists and fundamental analysts do not generally believe that any actionable information is contained within the historical price and volume data. To them, history does not repeat itself; rather, the prices move as a ‘random walk.’
The random walk theory suggests that changes in stock prices possess the same distribution and are independent of each other. For that reason, the past movement or trend of stock price or market cannot be predictive of its future movement. Basically, this is the idea that stocks go down a more random and unpredictable path.
An additional criticism of technical analysis is that it functions in some cases, but only because it establishes a self-fulfilling prophecy. For instance, many technical traders will usually place a stop loss order below the 200-day moving average of a specific company. If a large number of trades have in fact done so and the stock reaches this particular price, then there will be a large number of sell orders.
This, in turn, will push the stock down, thus confirming the movement that the traders anticipated. Following this, other traders will see the price decrease and also sell their positions, boosting the strength of the trend.
Short term selling pressure
This short-term selling pressure might often be self-fulfilling. But it will still have little bearing on where exactly the asset’s price will be weeks or even months from now. Essentially, if enough people utilize the same signals, they could cause the movement that was foretold by the signal. However, this sole group of traders would be unable to drive price in the long run.
All in all, technical analysis is an often overlooked component in trading and marketing. It’s a wise idea to familiarize yourself with its functions. That way you can not only better understand it but also differentiate it from fundamental analysis.
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