What it is and how to use it in investments

What is Technical Analysis?

Technical analysis is a trading discipline used to evaluate investments and identify trading opportunities by analyzing statistical trends gathered from trading activity, such as price movement and volume. Unlike fundamental analysis, which seeks to evaluate a security’s value based on business results such as sales and earnings, technical analysis focuses on the study of price and volume.

Understanding Technical Analysis

Technical analysis tools are used to examine the ways in which supply and demand for a security will affect changes in price, volume and implied volatility. It operates from the assumption that past trading activity and price changes of a security can be valuable indicators of the security’s future price movements when coupled with appropriate investment or trading rules.

It is often used to generate short-term trading signals from various charting tools, but can also help improve the evaluation of a security’s strength or weakness relative to the broader market or one of its sectors. This information helps analysts improve their overall valuation estimate.

Technical analysis as we know it today was first introduced in the late 1800s by Charles Dow and the Dow Theory. Several notable researchers including William P. Hamilton, Robert Rhea, Edson Gould and John Magee further contributed to Dow Theory concepts that helped form its basis. Nowadays, technical analysis has evolved to include hundreds of patterns and signals developed through years of research.

Use Technical Analysis

Professional analysts often use technical analysis in conjunction with other forms of research. Retail traders may make decisions based solely on a security’s price charts and similar statistics, but practicing stock analysts rarely limit their research to fundamental or technical analysis alone.

Technical analysis can be applied to any security with historical trading data. This includes stocks, futures, commodities, fixed income, currencies and other securities. In fact, technical analysis is much more common in commodities and forex markets where traders focus on short-term price movements.

Technical analysis attempts to predict the price movement of virtually any tradable instrument that is generally subject to forces of supply and demand, including stocks, bonds, futures, and currency pairs. In fact, some view technical analysis as simply the study of supply and demand forces as reflected in the market price movements of a security.

Technical analysis mostly applies to price changes, but some analysts track numbers other than just price, such as trading volume or open interest figures.

Technical Analysis Indicators

Across the industry, there are hundreds of patterns and signals developed by researchers to support technical analysis trading. Technical analysts have also developed numerous types of trading systems to help them predict price movements and trade.

Some indicators are primarily focused on identifying the current market trend, including support and resistance areas, while others are focused on determining the strength of a trend and the likelihood of its continuation. Commonly used technical indicators and charting patterns include trend lines, channels, moving averages and momentum indicators.

In general, technical analysts look at the following broad types of indicators:

Underlying Assumptions of Technical Analysis

There are two primary methods used to analyze securities and make investment decisions: fundamental analysis and technical analysis. Fundamental analysis involves analyzing a company’s financial statements to determine the fair value of the business, while technical analysis assumes that a security’s price already reflects all publicly available information and instead focuses on the statistical analysis of price movements.

Technical analysis seeks to understand the market sentiment behind price trends by looking for patterns and trends rather than analyzing a security’s fundamental characteristics.

Charles Dow has released a series of editorials discussing technical analysis theory. His writings included two basic assumptions that continue to form the framework for technical analysis trading.

Markets are efficient with values ​​representing factors that affect a security’s price, but even random market price movements appear to move in identifiable patterns and trends that tend to repeat over time.

Today, the field of technical analysis builds on Dow’s work. Professional analysts typically accept three general assumptions for the discipline:

The market discounts everything: Technical analysts believe that everything from a company’s fundamentals to broad market factors to market psychology is already priced into the stock. This view is consistent with the Efficient Markets Hypothesis (EMH) which assumes a similar conclusion about prices. The only thing left is the analysis of price movements, which technical analysts view as the product of supply and demand for a specific stock in the market. Price movements in trends: Technical analysts expect prices, even in random market movements, to show trends regardless of the time frame observed. In other words, a stock price is more likely to continue a past trend than to move erratically. Most technical trading strategies are based on this assumption. History tends to repeat itself: Technical analysts believe that history tends to repeat itself. The repetitive nature of price movements is often attributed to market psychology, which tends to be very predictable based on emotions such as fear or excitement. Technical analysis uses chart patterns to analyze these emotions and subsequent market movements to understand trends. While many forms of technical analysis have been used for over 100 years, they are still believed to be relevant because they illustrate patterns in price movements that often repeat themselves.

Technical Analysis vs Fundamental Analysis

Fundamental analysis and technical analysis, the most important schools of thought when it comes to approaching the markets, are on opposite ends of the spectrum. Both methods are used to research and predict future trends in stock prices, and like any investment strategy or philosophy, both have their proponents and detractors.

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 operating conditions to the financial condition and management of companies. Earnings, expenses, assets and liabilities are all important characteristics for fundamental analysts.

Technical analysis differs from fundamental analysis in that the stock’s price and volume are the only inputs. The core assumption is that all known fundamentals are factored into price; so there is no need to pay much attention to them. Technical analysts do not attempt to measure a security’s intrinsic value, but instead use stock charts to identify patterns and trends that suggest what a stock will do in the future.

Limitations of Technical Analysis

Some analysts and academic researchers expect the EMH to demonstrate why they should not expect any actionable information to be contained in historical price and volume data; by the same reasoning, business principles should also not provide any actionable information. These positions are known as the weak form and semi-strong form of the EMH.

Another criticism of technical analysis is that history does not repeat itself exactly, so price pattern study is of dubious importance and can be ignored. Prices appear to be better modeled by assuming a random walk.

A third 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 the 200-day moving average of a certain company. If a large number of traders have done this and the stock reaches this price, there will be a large number of sell orders, which will push the stock down, confirming the movement that traders expect.

Then other traders will see the price cut and sell their positions as well, reinforcing the strength of the trend. This short-term selling pressure can be seen as self-fulfilling, but it will have little bearing on where the asset’s price will be weeks or months from now.

In short, if enough people use the same signals, they can cause the movement predicted by the signal, but over the long term, this single group of traders cannot drive the price.

Chartered Market Technician (CMT)

Among professional analysts, the CMT Association supports the largest collection of chartered or certified analysts who use technical analysis professionally around the world. The association’s Chartered Market Technician (CMT) designation can be earned after three levels of exams that cover both a broad and deep look at technical analysis tools.

The association is now waiving Level 1 of the CMT exam for those who are Certified Financial Analyst (CFA) charter holders. This demonstrates how well the two disciplines reinforce each other.