If you’re interested in stocks, trading, and finances, then you might have heard the term ‘technical analysis’ thrown around before. But just what exactly does it mean and how is it relevant?
Here, we’ll go over the definition of technical analysis, break down its theory, look at the pros and cons of different approaches, and compare it to other forms of analysis. Keep reading to learn more about this interesting topic.
Source: Unsplash Alt text: Technical analysis chart on a computer screen
What Is Technical Analysis?
Technical analysis is a trading discipline that is used to identify trading opportunities as well as evaluate investments. This is done through an analysis of different trends that are identified by looking at the different trading activities. Essentially, technical analysis is just one way to see whether or not an investment is sound.
In technical analysis, experts look at trends in price changes, trading volume, and other charts to make predictions on the expected prices of things.
In this field, experts often rely on tools like statistics, data, and different financial charts to make their forecasts and look for signs of weakness in an investment.
Technical analysis is used to track and predict prices of a number of different securities aside from stocks and investments, such as currencies, commodities, and futures.
Technical Analysis Assumption
The technique of technical analysis relies on three main assumptions. These assumptions guide predictions and the process of analysis used to examine investments and other securities.
History Repeats Itself
One of the most popular rules in technical analysis is that history has a tendency of repeating itself.
Technical analysts have noticed that the price of securities usually moves in a cycle over the years. This means that sometimes trends are predicted based on what has already happened in the past.
Analysts look at past patterns to make their predictions. For example, past market patterns are analyzed to predict future trends.
Price and the Market Discounts Everything
Technical analysts don’t take different elements like the economy, financials, or the state of the market into consideration on an individual level.
Instead, they assume that these elements are already factored into the price, so it’s unnecessary to analyze them separately.
As an example, a technical analyst wouldn’t factor in world events, like a natural disaster, into their forecasting or market predictions. They focus primarily on charts, trends, and patterns and assume these events are already accounted for.
Prices Are Trend-Driven
Finally, the last assumption is that prices follow a trend and aren’t set randomly.
Essentially, this means that trading is most often based on probability instead of random events. Analysts wouldn’t assume that a market movement would suddenly move backward, but rather that it would continue its current pattern.
This assumption dictates that traders should trade with the trends and not against them.
Basics of Technical Analysis
Let’s take a look at some of the basics of technical analysis so we can get a better understanding of what elements are used to analyze stocks and other securities.
- Price: Technical analysts use charts to determine the price of a security as well as the trade volume in order to make predictions. Basically, these charts are used to point out patterns that can be used to identify trends and any changes over a period of time.
- Volume: Volume is the number of shares that trade over a determined period of time. Looking at volume is helpful in seeing the strength of a trend, seeing the trade direction, and confirming chart patterns.
- Chart patterns: Chart patterns are key to technical analysts since they play a major role in determining trends. Charts help provide a visual representation of elements like price trends and can help analysts make predictions of what a stock might do.
- Trend: As you can probably guess, trends are one of the most important things in technical analysis. Analysts examine historical trends to determine their forecast, but they also take things like human emotion and behavior into consideration.
- Momentum: In this context, momentum refers to the speed at which the price of a security changes. When analyzing momentum, you’re looking at the rate of change of a price over a set amount of time.
There are of course other elements that make up technical analysis that are used by industry experts, but these make up some of the basics of the trade.
Types of Technical Analysis
Source: Unsplash Alt text: Person looking at technical analysis chats on a phone and laptop
There are two primary types of technical analysis: top-down and bottom-up. Let’s take a closer look at each.
In the top-down approach, analysts will look at securities starting with the broadest viewpoint then moving on to more specific ones.
For example, analysts might take a top-down approach to how a stock performs over a determined period of time. First, they’ll analyze it on a daily basis, and then they’ll narrow it down and look at the performance per hour.
In this bottom-up approach, analysts are looking for undervalued stocks and securities or ones that are going against market trends.
This way, they can find the best possible entry and exit points in order to earn the most money possible.
Benefits and Drawbacks of Technical Analysis
Just like anything else, there are advantages and disadvantages to using technical analysis.
The benefits of technical analysis include the method of identifying market trends, which is invaluable information to any trader. Since these technical analysis rules and trends are so popular, they’re becoming more frequently used in the industry, which in turn can make the trends and rules function as a sort of self-fulfilling prophecy. As more people in the industry use the same trends and price points, the patterns will emerge and continue to be repeated.
On the other hand, technical analysis is often seen as at a disadvantage since it doesn’t account for a portion of market behavior that remains unpredictable. While historical trends and patterns have proven to be reliable, they’re not always entirely 100% accurate.
Technical Analysis vs. Fundamental Analysis: The Difference
These two approaches make up two opposing schools of thought in market analysis. While both types of analyses are used for the same purpose, that is determining trends, they use very different methodologies.
In fundamental analysis, the measurement is based on the intrinsic value of a stock. Fundamental analysis also looks at a lot more factors, such as the economy as a whole, current conditions in the industry, as well as company-specific information like sales, earnings, and assets.
By comparison, technical analysis really only focuses on two main elements: stock price and volume. As we saw earlier, technical analysts assume that all other elements are factored into the price, so they’re not as important to look at individually.
Additionally, instead of measuring the intrinsic value of a stock, technical analysis aims to determine future trends and patterns based on charts.
To Wrap Up
There’s a lot more that can be discussed about technical analysis, but hopefully, this gave you a good introduction to the field.
If you love working with numbers, statistics, and probabilities, then working as a technical analyst might be a really exciting career for you.
However, if you’re more interested in the business side of things instead of the actual analysis, you might benefit from studying in a field that is more focused on best business practices.
At University of the People, we offer tuition-free degrees in Business Administration. Since all courses take place online, you’ll have the flexibility to study from anywhere you’d like.