The Basics of Technical Analysis
Technical analysis is a type of analysis used to anticipate the future price movement of stock using market data, primarily price and volume, as opposed to fundamental analysis which seeks to determine the intrinsic value using financial statements and broader economic data.
Technical analysis is based on the idea that analysts and traders can predict future price movements just like they are able to discern previous market patterns. Technical analysts rarely analyze the fundamentals of a company as they believe these factors are already priced in the stock, disregarding the idea behind the intrinsic value.
Understanding Technical Analysis
When employing technical analysis, analysts and investors use different tools and indicators to analyze how will the two main market forces, supply, and demand, affect securities in terms of their price, volume, and volatility.
The main idea behind technical analysis is that it assumes that past trading and price trends of security can help anticipate future trends and price movements of a security, in combination with additional trading rules.
Using this approach, investors try to detect potential short-term trading signals and reinforce their research of a security’s advantages and weaknesses relative to the broader market.
Unlike fundamental analysis, technical analysis is based on the belief that current and past price and volume data of an asset represents the best indicator of future price changes. However, it should be noted that technical analysis is not employed only by technical traders.
Many investors who rely on fundamental analysis also conduct technical analysis after evaluating a company’s fundamentals, aiming to identify appealing entry and exit points.
Advantages of Technical Analysis
At the end of the previous part of the article, we said that technical analysis is commonly used for identifying potential entry and exit points. This is perhaps one of the key advantages of technical analysis as successfully detecting market and price trends are the core of any trading approach.
With both fundamental and technical traders regularly using the same technical indicators to identify support and resistance levels, as well as other important patterns, more market participants are brought together around the same important price points, which ultimately leads to the emergence of the same patterns.
Disadvantages of Technical Analysis
Just like any other trading strategy and approach, technical analysis also comes with its disadvantages. Given that technical analysts rely on a number of technical indicators, these indicators can often provide mixed trading signals that contradict each other.
For example, one technical indicator can display a buy signal while another one shows a sell signal, leading to confusion and making traders unsure about their decision. Because of this, more experienced traders try to analyze a combination of technical indicators and patterns to find the most reliable signal.
In addition, it is also important to point out that even though technical analysis can help find potential entry and exit points, it is not always 100% accurate. In other words, if a trader identifies an appealing entry or exit point to trade a stock, it doesn’t mean his trade will be successful for certain as stocks can easily move in an unexpected manner.
Another common occurrence with this type of analysis is that different technical analysts can have different opinions about the same security. This is mainly because not all technical analysts use completely the same methods and indicators to analyze a stock.
Using Technical Analysis
Technical analysis is based on the premise that all available market information is already priced in the security prices. As such, this theory disregards the idea behind the fundamental analysis, which aims to determine the intrinsic, or ‘real value’ of a stock.
Because of this, most technical analysts believe there is no need to look at the fundamentals as they believe this information is already reflected in the current market prices.
So what do technical analysts rely on? Well, the two main factors technical analysis covers are chart patterns and technical indicators.
Chart patterns represent formations created by price movements which traders and analysts look at to identify important price points and zones such as support and resistance. Supported by the market sentiment and certain psychological factors, analysts and traders use these chart patterns to try and predict future price movements.
Common chart patterns have their own names, with each one of them predicting certain price movements. For instance, a descending triangle is a chart pattern representing a bearish market downtrend. It is characterized by a horizontal support line and a descending resistance line, suggesting a potential downward price move.
On the other hand, technical indicators refer to mathematical patterns derived from historical price data, which traders and analysts also use to try and anticipate future price movements. Different technical indicators focus on exploring different factors.
For example, the primary goal of some of these indicators is to identify the latest trend, while others are developed to evaluate the strength of these trends and how long they may last.
There are numerous types of indicators and technical analysis tools traders look at to anticipate price movements, with some of the most common being moving averages, Moving Average Convergence Divergence (MACD), Fibonacci retracement levels, and more.
A moving average (MA) refers to an indicator used in technical analysis to predict the direction of a trend. To achieve this, the moving average sums up data points of an asset over a certain period of time and then divides the total by the number of data points to calculate the average value.
Because the average value is continuously recalculated using the most recent price data, the value changes, hence the name “moving” average.
There are several types of this indicator, with the most common being simple moving average (SMA) and exponential moving average (EMA).
Fibonacci Retracement Levels
Fibonacci Retracement is also a technical indicator that consists of horizontal lines that help indicate where support and resistance levels are likely to emerge.
Named after the Fibonacci sequence used in mathematics, the indicator analyzes different price levels, each associated with a percentage that represents how much of a previous move the price has retraced. The Fibonacci retracement levels used in technical analysis are 23.6%, 38.2%, 50%, 61.8%, and 78.6%.
Technical analysts and investors regularly use this indicator because it can be drawn between any two significant price points, most importantly highs and lows.
Traders also use Fibonacci Extension lines that identify levels of interest once support/resistance is broken.
Technical analysis is used for evaluating securities and anticipating future price movements using chart data, particularly price and volume. Technical analysis disregards the idea of intrinsic value, which is explored by fundamental analysis, as it believes all of the fundamentals are already reflected in current market prices.