What is Technical Analysis?

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Definition:

Technical analysis is an investing and trading strategy that relies on the study of a security’s market performance, including trade volume and price changes.

🤔 Understanding technical analysis

Technical analysis is a type of trading strategy that looks at data related to how a security trades on the stock market. Technical analysts look at things like trade volumes, price trends, moving averages, and other factors based on historical movements in a security’s price. This contrasts with fundamental analysis, which considers details about the underlying business or asset the security represents, such as the business’s revenue or profits. Technical analysis often includes looking at stock charts to identify patterns that technical analysts believe indicate how the security’s price will change in the future. Technical analysts typically use the strategy to make short-term trades rather than long-term investments.

Example

One common example of technical analysis involves tracking simple moving averages (SMAs) for a security’s price. SMAs track the average price of a security over a number of days. For example, a 50-day SMA tracks the average price over the past 50 days.

Many technical analysts look for a security’s current price to cross over its 50- or 200-day SMA. If the price crosses above the SMA, it may indicate that the security will continue to increase in price. If the price crosses below the SMA, it may show that its price is poised to drop further.

Takeaway

Technical analysis is like a baseball coach predicting a free agent’s potential…

When a baseball coach is deciding whether to sign a free agent, they might look at the player’s statistics, such as how many home runs they’ve hit and their batting average. The coach might also consider whether these stats are trending upward or downward. They can use this information to predict the player’s future performance. Technical analysis is similar because analysts consider historical price and volume trends, and use that information to try to predict future performance.

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What is technical analysis?

Technical analysis is a method of researching and selecting securities to buy and sell based on actions in financial markets. This contrasts with fundamental analysis, which tries to make investing decisions based on the underlying aspects of a business, such as its revenue, profit margins, and other factors.

Technical analysis involves looking at things like trade volume, trends in stock prices, and other patterns that appear on stock charts. Technical analysts believe that even if one could absorb and analyze all of the fundamental information related to a security, they could not accurately predict the precise movements of that security in the future. In the end, all publicly available information gets priced into a stock. Technical analysts believe that fundamental analysts, who aim to invest based on information that investors haven’t considered when pricing shares, cannot outperform because all fundamental information is already reflected in the stock’s price.

Technical analysts believe it is more profitable to try to follow trends and patterns in the market. These trends and patterns are created by people’s reaction to the market and changes in trade volumes and prices. Thus, they are likely to repeat themselves, giving technical analysts an opportunity to earn a profit by taking advantage of these patterns.

People who use technical analysis generally believe that markets react logically to changes in fundamentals. Businesses that report increased profits or revenue tend to gain price and vice versa. However, they also believe that technical patterns precede changes caused by publicly known fundamental changes.

Technical analysis is a type of behavioral finance because it aims to take advantage of the patterns created by human psychology, such as the tendency to believe that things that are gaining value continue to gain value or that patterns seen in the past will repeat themselves.

What are the types of technical analysis?

There are many types of technical analyses that people use based on how they view stock charts.

Candlestick

Candlestick charts show the change in a share’s price over a specific period of time. The candlestick’s body indicates the opening price and the closing price, while the wicks on the top and bottom show the lowest and highest prices the shares traded at during that period. You can chart candlesticks for many periods next to each other to see price changes over longer periods.

Commonly, periods with higher closing prices than opening prices use green candlesticks (typically used to show an increase in price), while days with lower closing prices than opening prices use red candlesticks (typically used to show a drop in price).

One indicator that technical analysts believe predicts an increase in a share’s price is the hammer. A hammer occurs during a downtrend and has a long wick below the body of the candle, but with a closing price that was ultimately above the open price.

This indicates that the share’s price dropped below its opening price during trading but managed to recover and grow before the day’s end.

Technical analysts believe that an inverse hammer, one with a tall upper wick, also indicates price growth going forward. The reasoning behind this is that the price wouldn’t increase without reason, so even though the shares closed below their highs, it will be easier for them to return to those highs in the future.

The morning star is another positive indicator formed by three candlesticks, one short candle in between a tall red candle and a tall green candle. This is seen as a positive indicator because it illustrates that the shares resisted going below a certain price, showing perceived strength in the company.

A negative indicator on a candlestick chart is the hanging man. The hanging man is similar to a hammer, in that it has a long bottom wick with a small drop from opening price to closing price. This indicates that prices dropped significantly from open but were pushed back up before closing. The difference is that the hanging man happens during an uptrend, and technical analysts believe it indicates future drops in a stock’s value.

Evening stars are another negative indicator. They are the opposite of morning stars and occur during an uptrend.

Bar

Bar charts are very similar to candlesticks in that they show the opening and closing prices of a security, as well as the highest and lowest prices it traded at over a day.

The primary difference is visual, with bar charts looking like a tree, with a branch on the left showing the open price and a branch on the right the close price. The trunk shows the range the security traded in over the day.

Because bar and candlestick charts are so similar, many of the technical analysis indicators used with candlestick charts work with bar charts.

Line

Line charts show changing closing prices for a security over a period. Line charts of a share’s price are often combined with line charts of the share’s moving average for use in technical analysis.

Moving averages show the average price for a security over the past N days. For example, a 50-day moving average shows the average price for a security over the past 50 days. Moving averages smooth out price fluctuations that can occur in the market, which can give investors a clearer picture of how a stock’s price has changed over time.

A common indicator that uses line charts and moving averages is a crossover. This occurs when a share’s price and its moving average (frequently 50-day or 200-day) intersect.

If the share price is crossing above the moving average, technical analysts see this as indicating continued growth in share prices. Conversely, share prices crossing below the moving average indicates further decreases in price.

Sometimes, technical analysts look for crossovers occurring between the 50-day and 200-day moving average. The short-term moving average crossing above the long-term average is seen as a positive indicator, while it crossing below the long-term average is seen as negative.

How is technical analysis used?

Technical analysis relies on three assumptions:

  • The market reflects all known information about a stock immediately.
  • Prices move in trends that can be observed by technical analysts.
  • History tends to repeat itself, so technical analysts can compare current price trends to historical ones to predict future price changes.

Based on these assumptions, technical analysts use their analysis to make decisions about when to buy and sell shares in the short-term. It’s frequently used by regular traders, rather than investors building a long-term portfolio, to inform their purchases and sales.

Positive technical indicators may encourage a technical analyst to buy more shares in a company. Negative indicators could prompt them to sell the shares they own or short (invest in a way that lets them profit from drops in those shares’ value) a stock using options to try to profit from price drops.

Does technical analysis work for stocks?

Whether technical analysis works for stock traders is a long-debated question.

In a study published in the Journal of Economic Behavior and Organization, researchers found that individual investors who use technical analysis tend to underperform. However, these investors also tended to exhibit other risky traits, such as frequent portfolio turnover, low levels of diversification, and higher levels of options trading than the average individual investor.

Other studies indicate that technical analysis is valuable to investors, accurately predicting future price movements. Not all commonly used indicators are fully effective, but there is potential for future learning and development of new algorithms and indicators that may be more effective in the future.

As with many investing strategies, technical analysis can be one tool that investors use to make decisions. However, no one can predict the future movement of stock prices. And all investing carries risk.

What is the difference between technical analysis and fundamental analysis?

Technical analysis and fundamental analysis are two different methods of predicting the future price of a security.

Fundamental analysis revolves around looking at the fundamental information about the underlying thing that a security represents. For a stock, that means looking at the business’s annual reports, competition, and investor communications, as well as larger macroeconomic trends.

Fundamental analysts believe that they can find a fair value for a security based on this information. For example, fundamental analysts looking at the prices of commodities like wheat or oranges look for things that will impact the growth of these crops and the demand for them. An early frost, which reduces production, should lead to higher prices.

Technical analysis ignores the underlying information about the thing a security represents. Instead, it looks purely at market data, such as historical prices and trade volume. Technical analysts believe that the market instantly prices in all publicly available information, making fundamental analysis useless.

Instead, technical analysts believe that market trends do a more effective job of predicting future price changes.

What are the limitations of technical analysis?

Technical analysis has many drawbacks that investors should keep in mind when employing strategies that rely on it.

One limitation is that there are so many different technical indicators that it’s easy to get a mixed signal. You might see an indicator on a candlestick chart that encourages you to buy while seeing an indicator on a line chart that encourages you to sell a stock.

Similarly, individual analysts may disagree as to what indicators they see on a chart. One analyst might see a hanged man or a morning star on a chart, while another doesn’t recognize the chart patterns the same way. This can lead to two investors making different predictions despite looking at the same chart.

Finally, technical analysts believe that the indicators can help predict future price movements, but the analysis isn’t always accurate. It also doesn’t indicate the precise times that investors should buy or sell. Instead, the analysis simply makes guesses about future trends.

Considerations in choosing a technical analysis strategy

Which technical analysis strategy some investors decide to use varies with a few factors.

One of the most important factors is what tools are available. Technical analysis relies on looking at charts and historical data. If the investing tools an investor has access to don’t provide candlestick charts or only give 50-day moving averages, the investor can’t rely on technical indicators that require other information.

Another consideration is the investing strategy. People who want to buy shares and sell them for a profit may wish to rely on technical analysis that identifies upward or downward trends in prices. If someone is open to trading options or other derivatives, they can use an analysis that helps to identify stocks poised to drop.

None of these tools can reliably predict future movements in stock prices. All investing carries risk.

What are the best resources for learning technical analysis?

Many brokers offer technical analysis tutorials that traders can use to learn more about how the process works. Many universities also offer classes on finance that include sections relating to technical analysis.

There are also many books written on the topic. The local library likely has a copy that one can check out to read about some of the strategies and indicators that are commonly used. If a trader prefers to learn online, there are many online courses and some technical analysis software includes built-in training and support.

Ready to start investing?
Sign up for Robinhood and get your first stock on us.Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory. Securities trading is offered through Robinhood Financial LLC.

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