Our overview of technical analysis covers differences between fundamental analysis, key terms, and risks.
In the mid-1700s, a rice merchant named Homma Munehisa tracked the price of rice while living in Sakata, Japan. Unfortunately for him, the most active rice exchange was in Osaka, Japan — 477 miles away.
This didn’t stop Homma. He placed a network of messengers every few miles between the cities to update him on prices. Using this information, he tracked those prices on parchment, where he recognized price patterns that are now called candlestick charts.
Though many traders still use candlestick charts today, technical analysis has evolved past a long game of telephone between hundreds of messengers. Now, traders have more access to historical market data. Many traders, particularly swing traders, analyze this information to make numbers-based decisions.
WHAT IS TECHNICAL ANALYSIS?
Technical analysis is the study of past market data, primarily price and volume. Technical analysts can use chart patterns as well as technical indicators to help identify trends. Analysts hope to use these statistical trends to help anticipate the direction of the market.
Two trends that technical analysts study include:
- Price: how much a single share of a security costs
- Volume: the number of shares of a security that are traded during a specific time frame
FUNDAMENTAL ANALYSIS VS. TECHNICAL ANALYSIS
People who use fundamental analysis attempt to measure stocks by their intrinsic value. This means they tend to study the financial strength and management of individual companies. Fundamental analysts can look at earnings, dividends, assets, expenses, and liabilities to inform their decisions. Additionally, fundamental analysts can consider overall economy and industry conditions, which could affect the price of an individual security.
On the other hand, people who rely on technical analysis focus on statistical patterns using charts and indicators. Many technical analysts assume all the known fundamentals are factored into a stock’s price, allowing them to focus on technical analysis. For many traders, using technical analysis can offer clearer entry and exit signals for their trades.
Many analysts incorporate a combination of fundamental and technical analysis when making decisions, while others focus exclusively on one or the other. Choosing the types of analysis to use can depend on an individual’s trading style, familiarity with the tools for analysis, or preference.
KEY TERMS IN TECHNICAL ANALYSIS
Trend: A trend is the overall direction of the price of a market or asset.
There are three directions for trends:
- Up (higher highs and lower lows in the price’s performance)
- Down (lower highs and lower lows)
- Sideways (relatively similar highs and lows)
Analysts determine a stock’s trend by how it’s generally performing. For example, if a stock has been going up, it could continue to keep going up.
Support and resistance: Support and resistance represent the levels in a trend that the price tends to stop and reserve.
- Support refers to the level of price below which the stock doesn’t fall during a certain period of time.
- Resistance refers to the level of price above which the stock doesn’t rise during a certain period of time.
One way to think about support and resistance is to consider drawing a line on either side of a stock’s general direction of a period time. If a stock breaks through either support or resistance, this could be a signal to enter or exit a trade. For example, if a stock breaks through resistance, it may keep going up, encouraging a trader to buy.
Source: Wikimedia Commons
Price patterns: A price pattern is a sequence of price movements on a chart.
Price patterns may appear as shapes of the support and resistance lines. Some examples include continuation patterns (such as triangles, flags, pennants, and wedges) and reversal patterns (such as head & shoulders and tops & bottoms).
Technical indicators: Technical indicators are graphical representations of chart data (such as price and volume). Because these indicators are based on mathematical formulas, these could be a more objective form of analysis.
One indicator is the moving average line, which measures the average of a security’s price over a period of time. For example, if an analyst was looking at a time frame of 50 days, they could compare the stock price’s direction with the average price during that time frame. If the stock goes above the 50-day moving average line, that could mean the stock is trending up.
RISKS OF TECHNICAL ANALYSIS
Technical analysis relies on using data from historical performance to indicate future performance. However, past performance does not necessarily represent future results, since there are many factors that can affect the market behavior.
Secondly, by the time an analyst identifies a trend, that could mean that most of that trend has already taken place. For instance, if a stock breaks through a resistance line, we can’t definitively predict how long that stock would continue its upward trend. In especially volatile or illiquid securities, accurately predicting its movement can be tricky.
Another risk with technical analysis is analyst bias. Although technical indicators are objective, traders can interpret that data differently, especially if they have a preconceived idea of what they may see. If someone thinks the market is bullish, their confirmation bias may encourage selecting only the results that suggest the market is bullish. Researching enough market history and using multiple indicators may help you develop a more comprehensive perspective.