Technical analysis is one method of analyzing potential investments to determine when to buy or sell them. It is based on the idea that supply and demand affect the price of a security and that changes in this can predict future movements. At a more precise level, technical analysis uses the study of past price movements in an attempt to determine future price movements for a particular security or group of securities.
How does technical analysis work?
There are three main principles of technical analysis:
The market process encompasses everything
The first principle of technical analysis is the fundamental belief that the efficient market hypothesis is correct. This means that all available information regarding the value of stocks is reflected in their prices. When new information becomes available that may affect the value of a stock, it is quickly and fully absorbed by the market and reflected in its price.
Prices move in trends
The second principle is based on the belief that prices will continue to move in the same direction until a technical indicator signals a reversal. There are many different technical indicators, and the specific indicator depends on the individual investor.
History repeats itself
The final principle of technical analysis is that historical patterns in stock price movements tend to repeat themselves. This aspect of technical analysis relies on market psychology to interpret patterns in price charts. Market psychology refers to the collective emotions of all investors, and the belief here is that this is what drives the highs and lows in security prices. When investors are optimistic about a security, they will buy it and push the price up. When that optimism wanes, they will sell, and the price will fall.
Methods of technical analysis
As mentioned earlier, technical analysis involves studying past market activity to determine a trend in the price of a security. There are many types of technical indicators, and most practitioners of technical analysis, known as chartists or technicians, will incorporate more than one indicator to make an investment decision.
Some examples of technical indicators include:
Bollinger Bands
Bollinger Bands compare the current moving average price of a security to the standard deviation of that same moving average. The current moving average is the moving average at the time of comparison. The standard deviation is a measure of how much the values deviate around the mean. The bands drawn above and below the moving average are called Bollinger Bands and are based on the standard deviation.
Average Volume
Average volume is the simple moving average of the number of shares traded over a specified period. For example, you can calculate the average daily volume over the past 60 days.
MACD
The Moving Average Convergence Divergence (MACD) compares the 26-period moving average with the 12-period moving average of the same price. You can approximate the MACD line by subtracting the 26-period moving average from the 12-period moving average and plotting the resulting value. To use MACD, compare it to a signal line, which is the 9-period moving average of the MACD line.
Alternatives to technical analysis
Fundamental analysis is another method for assessing investment decisions. It can be used alone or in conjunction with technical analysis. Fundamental analysis considers the value of a business entity to make investment decisions, rather than historical stock price patterns. The value of a company’s assets, debts, and operational performance issues, such as profitability and cash flow, are relevant data for conducting fundamental analysis. This information can be obtained from quarterly and annual financial statements, including the income statement, balance sheet, and cash flow statement.
Technical Analysis vs. Fundamental Analysis
| Technical Analysis | Fundamental Analysis |
|---|---|
| Decisions are based on market activity | Decisions are based on company data |
| Relies on charts | Relies on financial data |
Technical analysis is considered different from fundamental analysis in that fundamental analysis takes into account the underlying company data, while technical analysis relies solely on market data.
Conclusions
Main
Technical analysis involves studying past price movements to identify trends. The key data for conducting technical analysis on stocks are price and volume. There are many different types of technical indicators, which are often used in conjunction with one another and with other types of information. Technical analysis differs from fundamental analysis in that fundamental analysis considers the underlying data of the company, while technical analysis relies solely on market data.
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Sources:
The Wall Street Journal. “130 Years of History as Seen in the Pages of the Wall Street Journal.”
CFA Institute. “Technical Analysis.”
Source: https://www.thebalancemoney.com/what-is-technical-analysis-5113237
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