What is Technical Analysis?
Technical analysis is a trading tool used to evaluate investments and trading opportunities by conducting an analysis of the statistical trends gathered from trading activity such as price movement and volume. Technical analysis differs from fundamental analysis which evaluates a security based on business metrics such as sales and earnings. Technical analysis focuses on the trading price and volume of a security from market-based on market data.
Key Learning Points
- Technical analysis is a tool used to predict the probable future price movement of a security based on market data.
- Technical analysts believe that past trading activity like volume and price movement are valuable indicators for a security’s future price movements.
- The two important variables in technical analysis include the time frame and the technical indicator used by the analyst.
- Technical analysis studies a company’s historical price data while fundamental analysis focuses on a company’s financials and other fundamentals.
Understanding Technical Analysis
Technical analysis methods are employed to determine the way in which the supply and demand for a security will affect future changes in price, volume, and implied volatility. It was first introduced in the late 1800s by Charles Dow and the Dow Theory.
The theory that backs technical analysis is the notion that the collective actions of buying and selling by all market participants accurately reflects the relevant information related to a particular security. As a result, a fair market value is continually assigned to the security through these collective actions. Technical analysts use the past trading activity and price changes of a security as valuable indicators of the security’s future price movements.
Technical analysis is mostly used to generate short-term trading signals from various charting tools. However, it can also be used to evaluate a security’s strength or weakness relative to the whole market or a particular sector. This information assists analysts to get a better valuation estimate overall.
Any security with existing historical trading data can be subject to technical analysis. This includes stocks, futures, commodities, fixed-income securities, currencies, and other securities. Technical analysis is mostly used in the commodities and forex markets where traders focus on short-term price movements.
Technical analysis holds that the current or past price action in the market is a good indication of future price action. It is not only used by technical traders as many fundamental traders turn to technical analysis to determine good, but low risk buy entry price levels after carrying fundamental analysis to decide whether or not to buy into a market.
The aim of technical analysis is to forecast future price movements in a particular tradable security which is subject to the forces of demand and supply. It can be seen as the study of supply and demand of a security as reflected by the market price movements.
How Technical Analysis Works
Professional equity analysts use technical analysis paired with appropriate investing or trading rules to evaluate a security’s future price movements. Retail traders may make trading decisions based only on the price charts and trading volume of a security however, professionals will rarely limit their research to fundamental or technical analysis alone.
Technical analysts analyze price charts to attempt to predict price movements in a particular security. There are two primary variables involved in technical analysis namely, the time frames considered and the technical indicators a trader chooses to utilize.
The technical analysis time frames displayed on charts range from one-minute to monthly or even yearly time spans. The time frames employed depend on the trader’s personal trading style. Intra-day traders who open and close trading positions within a single trading day favor analyzing price movement on shorter time frame charts. On the other hand, long-term traders who hold market positions overnight and for extended periods will be more inclined to analyze markets using longer time frame charts.
Candlesticks are the most used method for displaying price movements on a chart. Technical analysis using a candlestick chart is often easier than using a standard bar chart because it provides the analyst with a lot more information from its visual cues and patterns. The highest point of a candlestick shows the highest price a security traded during a given period and the lowest point shows the lowest price a security traded during that period. The body of the candlestick indicates the opening and closing prices for the period. Some analysts assign color patterns to provide more informative readings. For instance, a blue candlestick shows the closing price was higher than the opening price while a red candlestick indicates the closing price was lower than the opening price during the period.
Technical traders have a number of technical indicators available to them to help them in making trading decisions. For instance, moving averages are one of the most used technical indicators. Traders use moving averages to pinpoint trade areas, spot trends and analyze markets. These indicators are used to determine the direction in which the security is trading. An example of a moving average trading strategy might be “Buy as long as price remains above the 50% exponential moving average (EMA), sell as long as price remains below the 50 EMA”. The higher a moving average number, the more significant the price movement in relation to it is considered.
Alternatively, technical traders can employ momentum indicators when conducting technical analysis. Momentum indicators focus on determining market strength unlike moving averages which determine market direction. These momentum indicators include popular tools such as the Stochastic Oscillator, Relative Strength Index (RSI), Moving Average Convergence-Divergence (MACD) indicator, and the Average Directional Movement Index (ADX).
Momentum indicators assist investors to determine the likelihood of the current price movement persisting. Since they measure trend strength, they can serve as an early warning signal that a trend is ending. If a security has been experiencing a significant prolonged upward trend and one or more momentum indicators signals that the trend is steadily losing strength, investors must start considering taking profits or reversing their trades.
Limitations of Technical Analysis
The efficient market hypothesis (EMH) holds that all available information about a security is priced into its stock. This, therefore, implies no actionable information can be obtained from fundamental analysis as well as historical price and volume data. These represent both the semi-strong and weak forms of the EMH.
Technical analysis works in some cases only because it is a self-fulfilling prophecy. This is due to the fact a large number of traders employ the same trading strategies when expecting outcomes. This then influences prices and as such influences other traders to follow the same strategy. If traders as such follow the same warning signals, their actions could cause the price movement foretold by the signal however, this group of traders cannot drive the price in the long run.
In addition, another criticism of technical analysis is that history does not exactly repeat itself and as a result, it is pointless to analyze past price performance. Prices are better modeled by assuming a random walk.
It is important to note that no technical or fundamental analysis indicators are perfect since they do not accurately predict future prices all the time. By studying historical price data on charts and employing various indicators, traders can predict price movements and implement the right trading strategies to reap what benefits they can. However, professional equity analysts do not limit their evaluations to technical analysis but include fundamental analysis when making investment decisions.
Technical Analysis – MCQ
Below is a multiple-choice question to test your knowledge, download the Excel exercise sheet attached to find a full explanation of the correct answer.