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Table of Contents:
- What is technical analysis?
- Understanding stock technical analysis
- Risks of technical trading
- Why use technical analysis?
- Tips for technical stock analysis
- The bottom line
As you start learning the basics of investing, you’ll come across various techniques that can help you make sense of it. When investors analyze stocks, they can base their interpretations on the fundamentals, such as earnings, costs, and industry trends, or look at past data focused on price movements and volume, which is called technical analysis.
What is technical analysis?
Technical analysis is the study of market action, primarily through the use of charts for the purpose of forecasting future price trends. It can be used as a guide for traders who focus on past price trends to help them decide how to invest.
Many technical traders regard past price movements to be the most significant signal of price action in the future and may evaluate stock pricing trends as part of their strategy. Technical indicators and chart patterns are 2 forms of technical analysis commonly used.
Although technical traders focus primarily on technical analysis as their main strategy, fundamental traders can also utilize it to further analyze whether a stock looks promising.
- Technical analysis focuses on evaluating charts and price patterns of stock trends and may include the use of behavioral economics, which is based on why people make financial decisions the way they do.
- Technical analysis is a visual tool used on price charts to evaluate the price movements of stocks, which can be calculated using volume, price, and time.
- A technical analyst considers price charts vital in providing all the relevant information needed to make educated decisions in making trades.
- Technical analysts try to determine if a price trend will continue or reverse and when those events may occur.
Understanding stock technical analysis
The introduction of technical analysis isn’t new. It dates back to the 17th century when Joseph de la Vega of Europe began using the technique to forecast Dutch markets. But more currently, Charles Dow and a variety of others began utilizing it to calculate the highs and lows of stock on charts instead of focusing on the details of the companies themselves.
In 1948, the diverse theories from Dow, Gould, Rhea, Hamilton, and others became known as technical analysis and were published by Robert D. Edwards and John Magee in their book, Technical Analysis of Stock Trends.
One of the technical tools includes Candlestick patterns, which are a technical tool that include information from various time frames and are added to a bar chart, have also been used throughout history and became popular in the early 1990s as day trading expanded among investors.
Although various candlestick patterns can be used to determine momentum and price changes, candlestick reversal patterns aim to help investors identify bearish trend reversals.
The use of technical indicators, which are pattern-based signals that use price trends, volume, chart patterns, and momentum, help investors to evaluate stocks and can provide insight into whether a trend will continue or not. Those indicators, along with market sentiment, make up the fundamentals of technical analysis.
As stated, there are 2 categories of technical analysis, chart patterns and technical indicators. Chart patterns are used to identify support levels, which are the lowest price a stock may fall for a certain period of time. Resistance levels refer to the price moving upward as pressure builds as sellers aim to sell at that price point. These patterns work in conjunction with investor sentiment to predict price trends in bullish or bearish markets.
Technical indicators use mathematical formulas that analysts apply to price and volume to find trends. Some of the most popular include:
- Trading volume – displays how many shares of the stock were traded over a defined time frame using colored bars to indicate price increases or decreases from the last price trend. They are often used along with other indicators to confirm trends.
- Relative strength index (RSI) – a momentum indicator that assesses the strength and weakness of the momentum measuring price changes to analyze potentially overbought and oversold stocks.
- Money flow index (MFI) – a momentum indicator that measures the flow of money into and out of an asset.
- Moving average – calculates the average price for a security over a specific period of time.
- Moving average convergence divergence (MACD) – a momentum indicator that shows the connection between moving averages and stock prices through trends.
- Support and resistance levels – display price points on a chart that identifies a pause in movement or a reversal in a trend. Support results when a downtrend is anticipated to stall due to high demand. Resistance results when an uptrend is expected to stall due to increased supply.
With so many variations available, traders often experiment with and choose to implement those they feel work best for them. As a result, it’s not uncommon for them to combine several indicators as a trading strategy.
Stock market technical analysis is widely used because investors can predict the price of a stock by researching patterns and signals over time. Since the focus is on past price movements, if data shows an increase or decrease at certain times, technical analysts tend to make decisions based on those movements.
Since analysts speculate that stock prices follow trends, they tend to examine supply and demand for various stocks by spotting patterns that can be short- or long-term trends that continue rather than experience short bursts of activity. They believe that these patterns repeat themselves over time, and charting them can help to improve decision-making.
Technical analysis vs. fundamental analysis
There are two separate camps for investors and analysts when it comes to how they approach the market.
Fundamental analysis studies stocks by evaluating their intrinsic value, which is the method of identifying the financial worth of a company and its cash flow.
Fundamental analysts research all financial markets and situations, such as industry news, the economy, how the company is managed, and all financial reports that show expenses, earnings, assets, and liabilities to evaluate the strength or weakness of the company and its financial health.
Technical analysis, on the other hand, focuses on trends that can be identified on charts that show movements in the volume and price of a stock that can indicate what they will do in the future rather than attempting to measure intrinsic value.
For fundamentalists, the theory is that price is already part of their analysis, so they don’t need to chart it as part of their research like technical analysts.
As you can see, both strategies can work despite the fact that they are worlds apart in their thought process for determining what stocks will offer greater returns.
Used to understand patterns in stock price and volume.
Used to understand financial performance.
Used for trading-related activities.
Used for investment-related activities.
Use of data
Focuses on previous data.
Focuses on current and previous data.
Identify entry and exit points in trading.
Identifying the intrinsic value of a stock.
Price and volume trends.
Examine price and market sentiment.
Industry trends, financials, economics, and competition.
Dow theory & price data.
Return on assets ROA & return on equity ROE.
Risks of technical trading
All trading strategies have limitations, and technical analysis is no exception. Some of them are simply due to the way information is interpreted and levels of trading experience, and some are because the data used to chart a pattern may not be accurate or is incomplete.
However, sometimes the limitations are due to how the investor does their research. Even though technical analysis focuses on using past data to predict future movements, some investors don’t always study all the stock charts that can offer that valuable information. Attention to detail and knowledge of a stock’s price history is the basis for technical analysis, so not putting in the time to get familiar with them may give disappointing results.
Why use technical analysis?
One of the reasons so many investors like using technical analysis is its simplicity to learn and put into practice. Simplicity doesn’t mean investors shouldn’t do their research. Every method takes time to understand, and even then, there are always risks. But, not everyone wants to dive deep into the background and financial history of a company either, so technical analysis offers another way.
- It takes less time to learn – those who follow technical analysis maintain that all the financial information they need is already done and is based on the market price, so following the data on price fluctuations and trading volume is what matters.
- Understanding chart patterns – charts make it easy to see price changes, volume, and patterns, which allows the focus to be on the execution of trades.
- Identifying trends – being able to identify trends is vital since the market is known to repeat them. Knowing when there’s a continuation of a trend, a stall, or a trend reversal offers investors opportunities to capitalize on when to enter or exit the market to profit from buying or selling at the optimal times.
- Strategic thinking – reading charts and patterns is a skill that allows for independence and personal trading style. Each trader may see new details that may not be evident to other traders.
- Utilizing resources effectively – analyzing charts helps identify the best time to buy and sell as you learn to see the signals.
Tips for technical stock analysis
In order to utilize chart patterns effectively, it’s essential to understand trendlines and how to draw them. They are used to identify trends and areas of support and resistance that display price changes and spot continuation or reversals in a trend. On a chart, they appear as a straight line that connects the highs and lows of prices change over time.
Since chart patterns offer so much insight into rising and falling trends, it’s essential to identify the most common patterns and what they mean.
To review, when a pattern continues in the same direction, it’s called a continuation pattern. When it signals a change in direction, it’s called a reversal pattern. Both are used to explore current price movements and predict future price movements.
The following are some of the most popular chart patterns:
Pennant – a continuation pattern that forms when a stock price moves upward and creates what looks like a flag pole, followed by a consolidation period or holding pattern where lines converge, forming the pennant before a breakout occurs.
Flag – a continuation pattern shaped like a sloping rectangle with support and resistance lines running parallel before a breakout.
Cup and handle – a continuation pattern that signifies a bullish trend with the rounded bottom and a handle that resembles a flag pattern.
Head and shoulders – an uptrend that is disrupted and resembles a large peak with 2 smaller peaks on each side. It’s used to predict bull or bear market trends. In a downtrend, the pattern may develop into a reverse head and shoulders pattern, which is the same pattern but inverted.
Triangles – 3 common triangles include the ascending, descending, and symmetrical. Ascending triangles have a level upper trendline with a lower trendline that is rising, which may indicate a breakout is going to occur. A descending triangle has a level lower trendline that trends downward, which may signal a breakout. And a symmetrical triangle that has 2 trend lines that converge toward each other may signal a breakout.
Candlestick patterns – as discussed, these are used to identify price movement based on past patterns. They help identify open, close, high, and low price points over a specific period of time.
Although technical analysis isn’t the only method available for investors, many find its simplicity a valuable tool in creating a trading strategy, even as a beginner. At first glance, it can feel overwhelming to learn, but keeping these things in mind can help.
- Learn the basics – technical analysis involves using charts to show the prices of stocks over a period of time. Its use of technical indicators assists in predicting future price movements based on past performance. The process can start simple, and as knowledge grows, so can the depth of analysis.
- The basis of technical analysis is to spot trends and follow them. When trends occur, make sure you understand what they mean before making trades. Both uptrends and downtrends can offer opportunities and risks.
- There are a variety of indicators that can be used. All indicators can be beneficial for spotting trends on when to buy or sell, but there isn’t one that’s considered to be better than the rest. Choosing which indicators to use is based on personal preference and understanding how they work. Strategies can include using more than one, but using too many at once can be confusing.
- Remember, even the most reliable indicators don’t always work. Investing is risky, and no matter how well an indicator has worked in the past, the risk is always part of the equation. Losses can and will occur sometimes. Factors such as unclear signals, market fluctuations, and knowledge base can all influence the outcomes. By using more than 1 indicator, you can view, evaluate, and confirm trends.
- Understand and accept market variations – having a method to manage profit and losses during volatile times is all part of utilizing technical analysis. Indicators aren’t always reliable, even when they have worked in the past.
- Make decisions based on the data. Charts are a clear way to see what’s really going on and should be evaluated before making decisions.
Investors don’t follow a one-size-fits-all approach, so having options when putting an investing plan together can be very beneficial. As you experiment with different methods and tools, note what you enjoy and build on those strategies. Before you know it, you’ll be comfortable enough to add even more to your investing toolkit.
The bottom line
Although technical analysis indicators are best used in conjunction with other tools such as charts, there are a variety to choose from to create a plan that works for you.
Every investor has a different approach based on their own risk tolerance, personality, and style, so developing your own trading strategies should take them into account. However, having an understanding of the indicators and how you can use them for your benefit is the first step.
When you’re ready to learn more about how to create your own investment plan and want to get started, download the Public app.