Technical Analysis

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What is Technical Analysis?

Technical analysis is a trading discipline that seeks to identify opportunities in the financial markets by analyzing statistical trends based on historical price movements and volume along with past trading activity.

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Unlike fundamental analysis, technical analysis does not attempt to measure a security’s intrinsic value. Instead, technical analysts focus solely on studying the price action of a given financial asset to make predictions about where the price may be headed in the future.

How Does Technical Analysis Work?

Technical analysts believe that all known fundamentals are already factored into a stock’s market price. As a result, they do not pay much attention to intrinsic value calculations, management performance, or other business metrics. The core assumption is that all public information is reflected in the stock‘s price path.

Instead, they study supply and demand dynamics through price trends and patterns. The repetitive nature of price movements is attributed to market participants’ psychological biases and emotions.

As fear and greed are repetitive traits, technicians expect similar price patterns to unfold throughout time. By scrutinizing price charts across different time horizons, analysts aim to forecast where the price is heading next.

The most common time frames studied include 1-minute, hourly, daily, and weekly charts spanning weeks to decades. Intraday scalpers may focus on 5-minute charts, while long-term investors examine multi-year weekly charts.

The goal is to identify trading opportunities by gaining an edge in determining situations where supply and demand are likely to shift, causing prices to change direction. This allows technical traders to target entries, stop losses and profit-taking levels.

Key Assumptions of Technical Analysis

Technical analysis operates under three core assumptions:

  • Prices Discount All Known Information: Current prices fully reflect all available information and represent the fair value of the asset. Technical analysts do not question whether an instrument is being properly valued or not. The actual market price is what matters most.
  • Price Moves in Trends: Price changes tend to trend and move in one direction for sustained periods despite random short-term fluctuations. This allows analysts to identify trading opportunities in the dominant direction of the trend.
  • History Tends to Repeat: Recurring price patterns provide predictive signals about the most likely future price movement. Past price behavior and extremes tend to act as support and resistance for future moves.

Technicians lean heavily on these assumptions to forecast where prices are heading next and solely rely on charts and market data instead of business results.

Types of Technical Analysis Indicators

5 Types of Technical Analysis Indicators

There is a vast array of technical indicators and chart patterns available, but most fall into the following five categories:

  1. Trend Lines: Identify areas of support or resistance through historical price extremes and trend channel boundaries.
  2. Moving Averages: Smooth out price data to more clearly identify the current market trend and direction.
  3. Momentum Oscillators: Gauge the rate of change in prices to determine overbought or oversold conditions.
  4. Volume Indicators: Utilize volume data to assess trading conviction behind price trends.
  5. Chart Patterns: Well-known classical chart formations that suggest likely future price movement when they emerge.

Beyond hundreds of specific technical indicators and systems, almost all technical analysis systems incorporate various metrics, including the ones cited above, when analyzing price charts to spot potential trading signals.

Implementing Technical Analysis

Technical analysis employs a top-down approach beginning with a broad market assessment. Here’s how that step-by-step process works:

Market Trend Analysis

Technicians determine the overall market trend across major indices like the S&P 500 for stocks or others that are considered representative of the type of asset that they will be trading. Most traders prefer to ‘follow the trend’ although some choose to be contrarian and place bearish bets in a bull market.

Sector Rotation Tracking

Specific sectors showing the most relative strength are typically favored if the market is trending higher. Meanwhile, the weakest sectors are preferred during bearish cycles.

Individual Stock Selection

After filtering first by sector, analysts select stocks that show technical alignment with the current market trend. They tend to lean toward chart patterns and indicator signals that can lead to major price movements that they can profit from the most.

Decisions are made constantly based on how the price is behaving and the different entry and exit targets the trader has established.

While fundamental developments contribute to shaping the price action, technical factors dominate the decision-making process for technical analysts.

Strengths and Weaknesses of Technical Analysis

As with all disciplines and approaches, technical analysis has its own set of pros and cons. Here’s a list of the strengths and weaknesses of this particular methodology.

Advantages

Advantages Description
Identify Trading Opportunities Charts help traders recognize key support/resistance levels, momentum shifts, and breakouts.
Risk Management Price/indicator discipline provides valid entries and exits that help traders keep their losses in check while profiting the most during upswings.
Trend Following By following the trend, traders increase the odds of turning a profit by choosing to stick to the path set forth by market participants.
Versatility Technical assessments can be applied to any liquid market with enough historical data.
Simplicity Pure price/volume analysis avoids the complexities of business valuation.

 

Disadvantages

Disadvantages Description
Subjectivity The interpretation of certain patterns and charts may differ among technicians.
Data Rationalization It is tempting to fit one’s analysis to preconceived views.
Lagging Nature By the time some trends are clear, much of the price movement has occurred.
Never Fully Proven Technical analysis indicators are probability tools, not foolproof predictive signals.
Prone to Failures No approach works 100% of the time across all conditions.

The arguments and discussions in favor and against technical analysis continue today. Used prudently, it can serve as an effective component of an overall investing approach. Technicians aim to tip odds favorably, not achieve perfection. Blending technical and fundamental analysis can overcome individual weaknesses.

Technical analysis provides trading rules based on price trends and patterns. By analyzing charts, it aims to forecast future price direction through supply and demand changes. Technicians believe that current prices already reflect all available information. While far from flawless, this practice offers measurable ways to identify and manage trading opportunities and signals.

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Alejandro Arrieche Rosas
Financial Reporter
Alejandro Arrieche Rosas
Financial Reporter

Alejandro has seven years of experience writing content for the financial industry and more than 17 years of combined work experience, serving under different roles in multiple business fields, including tech and financial services. Before joining Techopedia, Alejandro collaborated with numerous online publications such as Seeking Alpha, The Modest Wallet, Capital.com, Business2Community, EconomyWatch.com, and others, covering finance, business news, trading platform reviews, and educational articles for investors. Alejandro earned a Bachelor's in Business Administration from UNITEC, Venezuela, and a Master's in Corporate Finance from EUDE Business School, Spain. His favorite topics to cover are value investing and financial analysis.