TLDR - Technical Analysis
Technical Analysis is a trading discipline that evaluates investments and identifies trading opportunities by analyzing statistical trends from trading activity, such as price movement and volume. It contrasts with fundamental analysis, which focuses on a company's financials. Technical analysis is based on the belief that past trading activity and price changes can be valuable indicators of future price movements.
In this discussion, we will:
- Explore the concept of technical analysis and its key takeaways
- Understand the difference between fundamental and technical analysis
- Learn about the use of technical analysis in various markets
- Dive into the indicators used in technical analysis
- Discuss the underlying assumptions of technical analysis
- Compare technical analysis with fundamental analysis
- Address the limitations of technical analysis
- Conclude with a summary and FAQs
I. Understanding Technical Analysis
Technical analysis is a tool used to examine the ways supply and demand for a security will affect changes in price, volume, and implied volatility. It operates from the assumption that past trading activity and price changes can be valuable indicators of future price movements when paired with appropriate investing or trading rules. It's often used to generate short-term trading signals from various charting tools, but can also help improve the evaluation of a security's strength or weakness relative to the broader market or one of its sectors.
II. Fundamental vs. Technical Analysis
While fundamental analysis involves analyzing a company’s financial statements to determine the fair value of the business, 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.
III. Using Technical Analysis
Technical analysis can be applied to any security with historical trading data. This includes stocks, futures, commodities, fixed-income, currencies, and other securities. In fact, technical analysis is far more prevalent in commodities and forex markets where traders focus on short-term price movements. It attempts to forecast the price movement of virtually any tradable instrument that is generally subject to forces of supply and demand.
IV. Technical Analysis Indicators
There are hundreds of patterns and signals that have been developed by researchers to support technical analysis trading. Some indicators are focused primarily on identifying the current market trend, including support and resistance areas, while others are focused on determining the strength of a trend and the likelihood of its continuation. Commonly used technical indicators and charting patterns include trendlines, channels, moving averages, and momentum indicators.
V. Underlying Assumptions of Technical Analysis
Technical analysis builds on three general assumptions: The market discounts everything, price moves in trends, and history tends to repeat itself. The repetitive nature of price movements is often attributed to market psychology, which tends to be very predictable based on emotions like fear or excitement.
VI. Technical Analysis vs. Fundamental Analysis
Fundamental analysis and technical analysis are at opposite ends of the spectrum. Both methods are used for researching and forecasting future trends in stock prices. Fundamental analysis is a method of evaluating securities by attempting to measure the intrinsic value of a stock, while technical analysis uses stock charts to identify patterns and trends that suggest what a stock will do in the future.
VII. Limitations of Technical Analysis
Critics of technical analysis argue that it works in some cases but only because it constitutes a self-fulfilling prophecy. For example, if a large number of traders place a stop-loss order below the 200-day moving average of a certain company, the stock's price may decrease, confirming the movement traders anticipated. This short-term selling pressure can be considered self-fulfilling, but it will have little bearing on where the asset's price will be weeks or months from now.
Technical analysis is a valuable tool for traders and investors looking to identify trading opportunities and evaluate investments. It focuses on analyzing statistical trends from trading activity to predict future price movements. However, like any investment strategy, it has its limitations and should be used in conjunction with other forms of analysis to make informed trading decisions.
FAQ about Technical Analysis
1. What is the main purpose of technical analysis?
Technical analysis is used to evaluate investments and identify trading opportunities by analyzing statistical trends gathered from trading activity, such as price movement and volume.
2. How does technical analysis differ from fundamental analysis?
While fundamental analysis involves analyzing a company’s financial statements to determine the fair value of the business, technical analysis focuses on the statistical analysis of price movements.
3. Can technical analysis be used for all types of securities?
Yes, technical analysis can be applied to any security with historical trading data. This includes stocks, futures, commodities, fixed-income, currencies, and other securities.
4. What are some common technical analysis indicators?
Commonly used technical indicators and charting patterns include trendlines, channels, moving averages, and momentum indicators.
5. What are the limitations of technical analysis?
Critics argue that technical analysis can sometimes be a self-fulfilling prophecy and that it doesn't necessarily predict long-term price movements. It's also suggested that price patterns don't repeat exactly, making the study of past patterns of limited use.