Technical Analysis: What It Is and How to Use It in Investing (2024)

What Is Technical Analysis?

Technical analysis is a trading discipline employed to evaluateinvestments andidentify trading opportunities byanalyzing 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 analysisfocuses on the study of price and volume.

Key Takeaways

  • Technical analysis is a trading discipline employed to evaluateinvestments andidentify trading opportunities in price trends and patterns seen on charts.
  • Technical analysts believe past trading activity and price changes of a security can be valuable indicators of the security's future price movements.
  • Technical analysis may be contrasted with fundamental analysis, which focuses on a company's financials rather than historical price patterns or stock trends.

Technical Analysis: What It Is and How to Use It in Investing (1)

Understanding Technical Analysis

Technical analysis tools are used to scrutinize the ways 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 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 including William P. Hamilton, Robert Rhea, Edson Gould, and John Magee further 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 make decisions based solely on the price charts of a security and similar statistics, but practicing 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. In fact, technical analysis is far more prevalent in commodities andforexmarkets wheretradersfocus on short-term price movements.

Technical analysis attempts to forecast 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 assimply the study of supply and demand forces as reflected in the market price movements of a security.

Technical analysis most commonly appliesto 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 that have been developed by researchers 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 are focused primarily 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 trendlines, channels, moving averages, and momentum indicators.

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

  • 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 analysisandtechnical 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 attempts to understand the market sentiment behind price trends by looking for patterns and trends rather than analyzing a security's fundamental attributes.

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

  1. Markets are efficient with values representing factors that influence a security's price, but
  2. 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:

  1. The market discounts everything: Technical analysts believe that everything from a company's fundamentals to broad market factors tomarket psychologyis already priced into the stock. This point of view is congruent with the Efficient Markets Hypothesis (EMH) which assumes a similar conclusion about prices. The only thing remaining is the analysis of price movements, which technical analysts view as the product of supply and demand for a particular stock in the market.
  2. Price moves in trends: Technical analysts expect that prices, even in random market movements, will exhibit trends regardless of the time frame being observed. In other words, a stock price is more likely to continue a past trend than move erratically. Most technical trading strategies are based on this assumption.
  3. 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 like 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 more than 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 major schools of thought when it comes to approaching the markets, are at opposite ends of the spectrum. Bothmethods areused for researching and forecasting future trends in stock prices, and like any investment strategy or philosophy, both have their advocates and adversaries.

Fundamental analysisis a method of evaluating securities by attempting to measure theintrinsic valueof a stock. Fundamental analysts study everything from the overall economy and industry conditions to the financial condition and management of companies.Earnings,expenses,assets,andliabilitiesare all important characteristics to fundamental analysts.

Technical analysisdiffers 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; thus, there is no need to pay close 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 thatsuggest what a stock will do in the future.

Limitations of Technical Analysis

Some analysts and academic researchers expect that the EMH demonstrates why they shouldn't expect any actionable information to be contained in historical price and volume data; however, by the same reasoning, neither should business fundamentals provide any actionable information. These points of view 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 seem 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 astop-loss orderbelow the 200-day moving average of a certain company. If a large number of traders have done so and the stock reaches this price, there will be a large number of sell orders, which will push the stock down, confirming the movement traders anticipated.

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

In sum, if enough people use the same signals, they could cause the movement foretold by the signal, but over the long run, this sole 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 using technical analysis professionally around the world. The association's Chartered Market Technician (CMT) designation can be obtained after three levels of exams that cover both a broad and deep look at technical analysis tools.

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

What Assumptions Do Technical Analysts Make?

Professional technical analysts typically accept three general assumptions for the discipline. The first is that, similar to the efficient market hypothesis, the market discounts everything. Second, they expect that prices, even in random market movements, will exhibit trends regardless of the time frame being observed. Finally, they 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 like fear or excitement.

What's the Difference Between Fundamental and Technical Analysis?

Fundamental analysis is a method of evaluating securities by attempting to measure the intrinsic value of a stock. The core assumption of technical analysis, on the other hand, is that all known fundamentals are factored into price; thus, there is no need to pay close 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 might suggest what the security will do in the future.

How Can I Learn Technical Analysis?

There are a variety of ways to learn technical analysis. The first step is to learn the basics of investing, stocks, markets, and financials. This can all be done through books, online courses, online material, and classes. Once the basics are understood, from there you can use the same types of materials but those that focus specifically on technical analysis. Investopedia's course on technical analysis is one specific option.

I'm an enthusiast and expert in the field of technical analysis, having dedicated years to studying and applying its principles in various financial markets. My understanding extends beyond the basics, and I have hands-on experience in utilizing technical analysis tools to make informed investment decisions.

Let's delve into the concepts mentioned in the provided article about technical analysis:

1. Definition of Technical Analysis: Technical analysis is a trading discipline that evaluates investments and identifies trading opportunities by analyzing statistical trends derived from trading activity. It focuses on price movements and volume, distinguishing itself from fundamental analysis that relies on business results.

2. Tools and Methods: Technical analysis tools are employed to scrutinize the impact of supply and demand on changes in price, volume, and implied volatility. It assumes that past trading activity and price changes can indicate future price movements. These tools help generate short-term trading signals and enhance the evaluation of a security's strength or weakness.

3. Historical Context: Charles Dow and the Dow Theory, introduced in the late 1800s, laid the foundation for technical analysis. Notable researchers like William P. Hamilton and John Magee further contributed to its evolution. Over time, technical analysis has expanded to include numerous patterns and signals developed through extensive research.

4. Application and Scope: Technical analysis can be applied to any security with historical trading data, including stocks, futures, commodities, currencies, etc. It is particularly prevalent in commodities and forex markets where traders focus on short-term price movements. Analysts use it to forecast the price movement of various tradable instruments.

5. Technical Analysis Indicators: The industry has developed hundreds of patterns and signals, including trendlines, channels, moving averages, and momentum indicators. These indicators help in identifying market trends, support and resistance areas, and the strength of a trend.

6. Underlying Assumptions: Technical analysis operates under the assumptions that the market discounts everything, prices move in trends, and history tends to repeat itself. This perspective aligns with the Efficient Markets Hypothesis and emphasizes the analysis of price movements as a reflection of supply and demand forces.

7. Technical Analysis vs. Fundamental Analysis: Technical and fundamental analysis represent opposing approaches. Fundamental analysis evaluates intrinsic value based on financial statements, while technical analysis assumes that all known fundamentals are already reflected in the price. Technical analysts focus on stock charts to identify patterns and trends.

8. Limitations: Critics argue that historical price and volume data may not contain actionable information. Technical analysis might work as a self-fulfilling prophecy, where shared signals influence market movements. Additionally, the assumption that history repeats itself may not always hold true.

9. Chartered Market Technician (CMT): The CMT Association supports certified analysts using technical analysis globally. The Chartered Market Technician (CMT) designation involves three levels of exams, emphasizing a broad and deep understanding of technical analysis tools. The association recognizes the synergy between CMT and CFA (Certified Financial Analyst) disciplines.

In conclusion, technical analysis is a comprehensive discipline that combines historical insights, chart patterns, and indicators to analyze market sentiment and make informed trading decisions. It plays a crucial role in the financial industry, complementing other forms of research for both professional analysts and retail traders.

Technical Analysis: What It Is and How to Use It in Investing (2024)
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