Technical analysis is a trading discipline employed 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 attempts 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.
Key Takeaways
- Analyzing Price Trends: Technical analysis is a trading discipline employed to evaluate investments and identify trading opportunities in price trends and patterns seen on charts.
- Forecasting Future Movements: Technical analysts believe past trading activity and price changes of a security can be valuable indicators of the security’s future price movements.
- Contrasts with Fundamental Analysis: Technical analysis focuses on historical price patterns and stock trends, differing from fundamental analysis, which centers on a company’s financials.
Understanding Technical Analysis
Technical analysis tools are used to scrutinize supply and demand for a security, affecting 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 paired with appropriate investing 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 by Charles Dow and the Dow Theory in the late 1800s. Several noteworthy researchers contributed to Dow Theory concepts, helping to form its basis. Nowadays, technical analysis has evolved to include hundreds of patterns and signals developed through years of research.
Using Technical Analysis
Professional analysts often use technical analysis in conjunction with other forms of research. Retail traders may base decisions solely on the price charts of a security and similar statistics, but professional equity 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. It is far more prevalent in commodities and forex markets where traders focus on short-term price movements.
Technical analysis attempts to forecast the price movement of virtually any tradable instrument, including stocks, bonds, futures, and currency pairs. Some view technical analysis as the study of supply and demand forces as reflected in market price movements.
Technical analysis most commonly applies to price changes, but some analysts track other numbers, such as trading volume or open interest figures.
Technical Analysis Indicators
Across the industry, there are hundreds of patterns and signals that have been developed 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 focus primarily on identifying the current market trend, including support and resistance areas, while others focus on determining the strength of a trend and the likelihood of its continuation. Commonly used technical indicators and charting patterns include:
- Price trends
- Chart patterns
- Volume and momentum indicators
- Oscillators
- Moving averages
- Support and resistance levels
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 evaluating a company’s financials to determine the fair value, while technical analysis assumes that a security’s price already reflects all publicly available information and instead focuses on statistical analysis of price movements.
Technical analysis attempts to understand market sentiment behind price trends by looking for patterns and trends rather than analyzing a security’s fundamental attributes.
Charles Dow’s writings included two assumptions that form the framework for technical analysis:
- Market Efficiency: Markets are efficient with values representing factors that influence a security’s price.
- Identifiable Patterns: Even random market price movements tend to move in identifiable patterns and trends over time.
Nowadays, professional analysts typically accept three general assumptions for technical analysis:
- Market Discounts Everything: Analysts believe that everything from a company’s fundamentals to broad market factors to market psychology is already priced into the stock.
- Prices Move in Trends: Prices exhibit trends regardless of the observed time frame, making most technical trading strategies trend-based.
- History Repeats Itself: Price movements repeat themselves due to market psychology, illustrated by chart patterns in technical analysis.
Technical Analysis vs. Fundamental Analysis
Fundamental analysis focuses on evaluating securities by measuring intrinsic value, considering aspects such as earnings, expenses, assets, and liabilities. Technical analysis, on the other hand, focuses solely on a stock’s price and volume, assuming that all known fundamentals are already factored into the price.
Technical analysts use stock charts to identify patterns and trends that might suggest what a stock will do in the future.
Limitations of Technical Analysis
Some analysts believe that business fundamentals, rather than historical price and volume data, provide actionable information, as supported by the Efficient Market Hypothesis (EMH). Others criticize that history does not exactly repeat itself, making price pattern study of dubious importance.
A third criticism is that technical analysis can work as a self-fulfilling prophecy. For example, if many traders place a stop-loss order below the 200-day moving average, reaching this price could trigger a massive amount of sell orders, reinforcing the anticipated movement. Although this short-term selling pressure is driven by the traders’ expectations, it cannot sustain the price over the long term.
Chartered Market Technician (CMT)
Among professional analysts, the Chartered Market Technician (CMT) designation is noteworthy. Supported by the CMT Association, the designation can be obtained after three levels of extensive exams that delve into technical analysis tools.
What Assumptions Do Technical Analysts Make?
Technical analysts make several core assumptions:
- The market discounts everything.
- Prices move in trends.
- History tends to repeat itself, due to predictable market psychology based on emotions like fear or excitement.
What’s the Difference Between Fundamental and Technical Analysis?
Fundamental analysis attempts to evaluate intrinsic value, while technical analysis assumes all fundamentals are already factored into the price and focuses on identifying patterns through stock charts.
How Can I Learn Technical Analysis?
Learning technical analysis can begin with understanding basics of investing, stocks, markets, and financials through books, online courses, and classes. Specialized technical analysis materials can then be used for deeper learning.
Related Terms: fundamental analysis, chartered market technician, trading discipline, market trends.
References
- John J. Murphy. Technical Analysis of the Financial Markets: A Comprehensive Guide to Trading Methods and Applications, Page 23. Penguin, 1999.
- CFA Institute Research Foundation. “Technical Analysis: Modern Perspectives”, Page 1.
- CMT Association. “Technical Analysis: Three Premises”.
- CMT Association. “Enroll in the CMT Program”.
- CMT Association. “Level I Waiver for CFA Charterholders”.
