What Is Technical Analysis? – Basics, Underlying Assumptions, and More
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What Is Technical Analysis?
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 research focuses on price and volume. Technological analysis tools use to scrutinize the ways supply and demand for security will affect price, volume, and implied volatility.
Technical analysis often uses to generate short-term trading signals from various charting tools and help improve the evaluation of a security’s strength or weakness relative to the broader market or one of its sectors. This information allows analysts to enhance their overall valuation estimate.
Technical analysis can use on any security with historical trading data. This includes stocks, futures, commodities, fixed-income, currencies, and other securities. In this tutorial, we’ll usually analyze stocks in our examples, but keep in mind that these concepts can apply to any security. Technical analysis is far more prevalent in commodities and forex markets, where traders focus on short-term price movements.
The Basics Of Technical Analysis
As we know it today, technical analysis 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’s concepts helping to form its basis.
In the modern-day, technical analysis has evolved to included hundreds of patterns and signals developed through years of research.
Technical analysis operates from the assumption that past trading activity and price changes of security can be valuable indicators of the security’s future price movements when paired with appropriate investing or trading rules.
Professional analysts often use technical analysis in conjunction with other forms of research. Retail traders may decide based solely on the price charts of a security and similar statistics, but practising equity analysts rarely limit their research to fundamental or alone.
The CMT Association supports the most extensive collection of chartered or certified analysts using technical analysis professionally worldwide among professional analysts.
The association’s Chartered Market Technician (CMT) designation can obtain three exams covering both a broad and deep look at technical analysis tools.
Nearly one-third of CMT charter holders are also Certified Financial Analyst (CFA) charter holders. This demonstrates how well the two disciplines reinforce each other.
The 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.
In contrast, 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.
Markets are efficient with values representing factors that influence a security’s price, but
Even random market price movements appear to move identifiable patterns and trends that tend to repeat over time.
Today the field builds on Dow’s work. Professional analysts typically accept three general assumptions for the discipline:
1: The Market Discounts Everything
Technical analysts believe everything from a company’s fundamentals to broad market factors to market psychology already prices 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 market.
2: Price Moves in Trends
Technical analysts expect that prices will exhibit trends regardless of the time frame observe, even in random market movements.
In other words, a stock price is more likely to continue a past trend than move erratically—most technical trading strategies base on this assumption.
3: History Tends to Repeat Itself
Technical analysts believe that history tends to repeat itself. The repetitive nature of price movements often attributes to market psychology, which tends to be predictable based on fear or excitement.
Technical analysis uses chart patterns to analyze these emotions and subsequent market movements to understand trends.
While many firms have used for more than 100 years, they still believe to be relevant because they illustrate patterns in price movements that often repeat themselves.
How Is Technical Analysis Used?
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.
Some view it as simply studying supply and demand forces as reflected in the market price movements of a security.
Technical analysis most commonly applies to price changes, but some analysts track numbers other than just prices, such as trading volume or open interest figures.
Across the industry, there are hundreds of patterns and signals that researchers have developed to support technical analysis trading. Technical analysts have also set numerous 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. In contrast, others are focused on determining the strength of a movement 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:
Volume and momentum indicators
Support and resistance levels
The Difference Between Technical Analysis And Fundamental Analysis
Fundamental analysis and technical analysis, the primary schools of thought when approaching the markets, are at opposite ends of the spectrum.
Both methods use for researching and forecasting future trends in stock prices, and like any investment strategy or philosophy, both have their advocates and adversaries.
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 industry conditions to companies’ financial situation and management.
Earnings, expenses, assets, and liabilities are all essential characteristics to 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 factor 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 suggest 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 contain 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 ignore. Prices seem to better model by assuming a random walk.
A third criticism 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 particular company.
If a large number of traders have done so and the stock reaches this price. There will be many sell orders, which will push the stock down, confirming the movement traders anticipated.
Then, other traders will see the price decrease and sell their positions, reinforcing the trend’s strength.
This short-term selling pressure can be considered self-fulfilling. 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 sign. But this only group of traders cannot drive the price over the long run.
Technical analysis is a trading discipline employed to evaluate investments. And identify trading opportunities in price trends and patterns seen on charts.
Technical analysts believe past trading activity and price changes can be valuable indicators of future price movements’ security.
It may contrast with fundamental analysis, which focuses on a company’s financials rather than historical price patterns or stock trends.