Technical Analysis: What It Is and How to Use It in Investing (2023)

What Is Technical Analysis?

Technical analysis is a trading discipline employed to evaluateinvestments andidentify trading opportunities byanalyzing statistical trends gathered from trading activity, such as price movement and volume. Unlike fundamental analysis, which attempts to evaluate a security's value based on business results such as sales and earnings,technical analysisfocuses on the study of price and volume.

Key Takeaways

  • Technical analysis is a trading discipline employed to evaluateinvestments andidentify trading opportunities in price trends and patterns seen on charts.
  • Technical analysts believe past trading activity and price changes of a security can be valuable indicators of the security's future price movements.
  • Technical analysis may be contrasted with fundamental analysis, which focuses on a company's financials rather than historical price patterns or stock trends.

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Understanding Fundamental Vs. Technical Analysis

Understanding Technical Analysis

Technical analysis tools are used to scrutinize 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 of a security can be valuable indicators of the security's future price movements when paired with appropriate investing or trading rules.

It is 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. This information helps analysts improve their overall valuation estimate.

Technical analysis as we know it today was first introduced by Charles Dow and the Dow Theory in the late 1800s. Several noteworthy researchers including William P. Hamilton, Robert Rhea, Edson Gould, and John Magee further contributed to Dow Theory concepts helping to form its basis. Nowadays technical analysis has evolved to include hundreds of patterns and signals developed through years of research.

Using Technical Analysis

Professional analysts often use technical analysis in conjunction with other forms of research. Retail traders may make decisions based solely on the price charts of a security and similar statistics, but practicing equity analysts rarely limit their research to fundamental or technical analysis alone.

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 andforexmarkets wheretradersfocus on short-term price movements.

Technical analysis attempts to forecast the price movement of virtually any tradable instrument that is generally subject to forces of supply and demand, including stocks, bonds, futures, and currency pairs. In fact, some view technical analysis assimply the study of supply and demand forces as reflected in the market price movements of a security.

(Video) Investing Basics: Technical Analysis

Technical analysis most commonly appliesto price changes, but some analysts track numbers other than just price, such as trading volume or open interest figures.

Technical Analysis Indicators

Across the industry, there are hundreds of patterns and signals that have been developed by researchers to support technical analysis trading. Technical analysts have also developed numerous types of trading systems to help them forecast and trade on price movements.

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.

In general, technical analysts look at the following broad types of indicators:

  • Price trends
  • Chart patterns
  • Volume and momentum indicators
  • Oscillators
  • Moving averages
  • Support and resistance levels

Underlying Assumptions of Technical Analysis

There are two primary methods used to analyze securities and make investment decisions:fundamental analysisandtechnical analysis. Fundamental analysis involves analyzing a company’s financial statements to determine the fair value of the business, while 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.

Charles Dow released a series of editorials discussing technical analysis theory. His writings included two basic assumptions that have continued to form the framework for technical analysis trading.

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  1. Markets are efficient with values representing factors that influence a security's price, but
  2. Even random market price movements appear to move in identifiable patterns and trends that tend to repeat over time.

Today the field of technical analysis builds on Dow's work. Professional analysts typically accept three general assumptions for the discipline:

  1. The market discounts everything: Technical analysts believe that everything from a company's fundamentals to broad market factors tomarket psychologyis already priced into the stock. This point of view is congruent with the Efficient Markets Hypothesis (EMH) which assumes a similar conclusion about prices. The only thing remaining is the analysis of price movements, which technical analysts view as the product of supply and demand for a particular stock in the market.
  2. Price moves in trends: Technical analysts expect that prices, even in random market movements, will exhibit trends regardless of the time frame being observed. In other words, a stock price is more likely to continue a past trend than move erratically. Most technical trading strategies are based on this assumption.
  3. History tends to repeat itself: Technical analysts believe that 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. Technical analysis uses chart patterns to analyze these emotions and subsequent market movements to understand trends. While many forms of technical analysis have been used for more than 100 years, they are still believed to be relevant because they illustrate patterns in price movements that often repeat themselves.

Technical Analysis vs. Fundamental Analysis

Fundamental analysis and technical analysis, the major schools of thought when it comes to approaching the markets, are at opposite ends of the spectrum. Bothmethods areused for researching and forecasting future trends in stock prices, and like any investment strategy or philosophy, both have their advocates and adversaries.

Fundamental analysisis a method of evaluating securities by attempting to measure theintrinsic valueof a stock. Fundamental analysts study everything from the overall economy and industry conditions to the financial condition and management of companies.Earnings,expenses,assets,andliabilitiesare all important characteristics to fundamental analysts.

Technical analysisdiffers from fundamental analysis in that the stock's price and volume are the only inputs. The core assumption is that all known fundamentals are factored into price; thus, there is no need to pay close attention to them. Technical analysts do not attempt to measure a security's intrinsic value, but instead, use stock charts to identify patterns and trends thatsuggest what a stock will do in the future.

Limitations of Technical Analysis

Some analysts and academic researchers expect that the EMH demonstrates why they shouldn't expect any actionable information to be contained in historical price and volume data; however, by the same reasoning, neither should business fundamentals provide any actionable information. These points of view are known as the weak form and semi-strong form of the EMH.

Another criticism of technical analysis is that history does not repeat itself exactly, so price pattern study is of dubious importance and can be ignored. Prices seem to be better modeled by assuming a random walk.

A third criticism of technical analysis is that it works in some cases but only because it constitutes a self-fulfilling prophecy. For example, many technical traders will place astop-loss orderbelow the 200-day moving average of a certain company. If a large number of traders have done so and the stock reaches this price, there will be a large number of sell orders, which will push the stock down, confirming the movement traders anticipated.

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Then, other traders will see the price decrease and also sell their positions, reinforcing the strength of the trend. 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.

In sum, if enough people use the same signals, they could cause the movement foretold by the signal, but over the long run, this sole group of traders cannot drive the price.

Chartered Market Technician (CMT)

Among professional analysts, the CMT Association supports the largest collection of chartered or certified analysts using technical analysis professionally around the world. The association's Chartered Market Technician (CMT) designation can be obtained after three levels of exams that cover both a broad and deep look at technical analysis tools.

The association now waives Level 1 of the CMT exam for those who are Certified Financial Analyst (CFA) charterholders. This demonstrates how well the two disciplines reinforce each other.

What Assumptions Do Technical Analysts Make?

Professional technical analysts typically accept three general assumptions for the discipline. The first is that, similar to the efficient market hypothesis, the market discounts everything. Second, they expect that prices, even in random market movements, will exhibit trends regardless of the time frame being observed. Finally, they believe that 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.

What's the Difference Between Fundamental and Technical Analysis?

Fundamental analysis is a method of evaluating securities by attempting to measure the intrinsic value of a stock. The core assumption of technical analysis, on the other hand, is that all known fundamentals are factored into price; thus, there is no need to pay close attention to them. Technical analysts do not attempt to measure a security's intrinsic value, but instead, use stock charts to identify patterns and trends that might suggest what the security will do in the future.

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How Can I Learn Technical Analysis?

There are a variety of ways to learn technical analysis. The first step is to learn the basics of investing, stocks, markets, and financials. This can all be done through books, online courses, online material, and classes. Once the basics are understood, from there you can use the same types of materials but those that focus specifically on technical analysis. Investopedia's course on technical analysis is one specific option.

FAQs

What is technical analysis in investing? ›

Technical analysis is a form of security analysis that uses price data and volume data, typically displayed graphically in charts. The charts are analyzed using various indicators in order to make investment recommendations.

What are the 4 basics of technical analysis? ›

Technical Analysis: Four Basic Principles
  • Markets alternate between range expansion and range contraction. ...
  • Trend continuation is more likely than reversal. ...
  • Trends end in one of two ways: climax or rollover. ...
  • Momentum precedes price.

What is technical analysis and how does it work? ›

Technical analysis seeks to predict price movements by examining historical data, mainly price and volume. It helps traders and investors navigate the gap between intrinsic value and market price by leveraging techniques like statistical analysis and behavioral economics.

What is the main purpose or use of technical analysis? ›

The purpose of technical analysis is to identify trend changes that precede the fundamental trend and do not (yet) make sense if compared to the concurrent fundamental trend.

How technical analysis is useful to investors? ›

Technical analysis is a trading discipline employed to evaluate investments and identify trading opportunities in price trends and patterns seen on charts. Technical analysts believe past trading activity and price changes of a security can be valuable indicators of the security's future price movements.

Is technical analysis important for investing? ›

Investing in the stock market requires caution and a fair bit of knowledge such that investors continue to incur profits rather than losses. Stock chart technical analysis, therefore, plays an important role as it helps investors and traders alike in making informed decisions.

How do you master technical analysis? ›

How to learn technical analysis
  1. Learn the basics. Before you use technical analysis to make informed trading decisions, it's important to understand fundamentals of this discipline and its core concepts. ...
  2. Practice your skills in a controlled environment. ...
  3. Apply your training to real trades. ...
  4. Continue your education.
Dec 7, 2021

How can I teach myself technical analysis? ›

The best way to learn technical analysis is to gain a solid understanding of the core principles and then apply that knowledge via backtesting or paper trading. Thanks to the technology available today, many brokers and websites offer electronic platforms that offer simulated trading that resemble live markets.

Which technical indicator is the most accurate? ›

MACD - Moving Average Convergence/Divergence

Several indicators in the stock market exist, and the Moving-Average Convergence/Divergence line or MACD is probably the most widely used technical indicator.

Is technical analysis enough for trading? ›

Yes, Technical Analysis works and it can give you an edge in the markets. However, Technical Analysis alone is not enough to become a profitable trader. You must have: A trading strategy with an edge.

What is technical analysis in simple words? ›

We can define technical analysis as a trading discipline that is used for the evaluation of investments and identification of trading opportunities. It is done by analyzing the trends in statistics that are collected from trading activities such as movement of price and volume.

How do you analyze stocks before buying? ›

How to do Fundamental Analysis of Stocks:
  1. Understand the company. It is very important that you understand the company in which you intend to invest. ...
  2. Study the financial reports of the company. ...
  3. Check the debt. ...
  4. Find the company's competitors. ...
  5. Analyse the future prospects. ...
  6. Review all the aspects time to time.

How do traders predict the market? ›

Traders use upward and downward movements of the market to decide whether to buy or sell shares. Sometimes, traders may take calls, based on previous similar trends and share market analysis, to hold on to stocks that have done well in the past.

How do you technically analyze a stock? ›

The two major types of technical analysis are chart patterns and technical (statistical) indicators. Chart patterns are a subjective form of technical analysis where technicians attempt to identify areas of support and resistance on a chart by looking at specific patterns.

How do you use technical analysis? ›

How to do technical analysis
  1. Identifying the trend. This is the first step in technical analysis for traders because trading strategies can either follow the trend or go against the trend. ...
  2. Drawing support and resistance levels. ...
  3. Establishing entry and exit points. ...
  4. Position sizing and risk management.
Jul 27, 2021

Do real traders use technical analysis? ›

Some traders use strict technical trading rules, others take a discretionary approach. Moving averages, technical indicators that measure if a stock is overbought or oversold, trading volumes, chart patterns, measures of market sentiment – these and other tools are used by the technical community.

Why is technical analysis the best? ›

Technical analysis can be used to improve timing, and to trade strategies appropriate to market conditions. It can improve hedging strategies by improving your timing when short selling or buying options. By looking at a chart you can quickly see whether a stock price is in a trading range or a trend.

Do most traders use technical analysis? ›

Technical analysis is not only used by technical traders. Many fundamental traders use fundamental analysis to determine whether to buy into a market, but having made that decision, then use technical analysis to pinpoint good, low-risk buy entry price levels.

How long does it take to learn technical analysis? ›

How long does it take to learn Technical Analysis? Up to 6 months, with 1-2 hours of practice every day. Trading can be easily managed even while working, however, you will need to devote 1,000 days to become a Pro, just as you would for your enterprise to take off and flourish.

Which tool is best for technical analysis? ›

Top 5 Technical Analysis Tools for the Stock Market
  • Screener Plus.
  • Thinkorswim.
  • Active Trader Pro.
  • Slope of Hope.
  • Interactive Brokers.
  • Conclusion.
Jun 12, 2022

Which is the best place to learn technical analysis? ›

Best Technical Analysis Courses in 2023
  • Best Overall: Udemy.
  • Best for Beginners: Travis Rose.
  • Best for Learning While Trading: Bullish Bears.
  • Best for Charting Services: StockCharts.
  • Best for Comprehensive Offering: Chart Guys.
  • Best for Learning From One of the Greats: Charting School.

What is the best way to learn trading? ›

Learn how to trade stock for beginners:
  1. Read books.
  2. Follow a mentor.
  3. Take online courses.
  4. Get expert advice.
  5. Analyse the market.
  6. Open a demat and trading account.

Is technical analysis a skill? ›

Technical analysis is an incredibly important skill for anyone who works with buying and selling securities. If you have work or internship experience that involved doing a technical analysis of a stock or commodity, mention that in your resume.

What skills do you need to be a technical analyst? ›

Required Skills/Abilities:
  • Excellent verbal and written communication skills.
  • Excellent interpersonal skills with a bility to explain technical issues to technical and nontechnical staff.
  • Strong analytical and problem-solving skills.
  • Superior understanding of computer and networking hardware and software systems.

Which is the most powerful indicator? ›

Seven of the best indicators for day trading are:
  • On-balance volume (OBV)
  • Accumulation/distribution line.
  • Average directional index.
  • Aroon oscillator.
  • Moving average convergence divergence (MACD)
  • Relative strength index (RSI)
  • Stochastic oscillator.

What indicator do most traders use? ›

Traders often hear about daily moving averages (DMA), which is the most common and widely used indicator. The moving average is a line on the stock chart that connects the average closing rates over a specific period. The longer the period, the more reliable the moving average.

Do professional traders use indicators? ›

Professional traders who rely on technical analysis use indicators. Professional traders who do not rely on technical patterns tend to keep the use of indicators to a minimum, if at all. Trading indicators analyze the statistical trends of price movements and trading volume to predict market trends.

Do stock brokers use technical analysis? ›

Traders often use technical analysis to attempt to profit from short-term -- daily, weekly, or monthly -- volatility in a stock's price.

How accurate is technical analysis in stock market? ›

While it is sure that technical analysis cannot assure a 100% success rate or magically high profits- it is however a very thorough study of how to predict equity market share value and thus can be considered a format of trade prediction.

Does technical analysis Really Work? ›

Technical analysis (TA) tries to capture market psychology and sentiment by analyzing price trends and chart patterns for possible trading opportunities. Many opponents of TA subscribe to myths about the strategy. Common myths about TA include it being only for day trading and only used by individual traders.

What is the best technical analysis for stocks? ›

MACD - Moving Average Convergence/Divergence

Several indicators in the stock market exist, and the Moving-Average Convergence/Divergence line or MACD is probably the most widely used technical indicator.

Is technical analysis worth anything? ›

Technical analysis can be used to improve timing, and to trade strategies appropriate to market conditions. It can improve hedging strategies by improving your timing when short selling or buying options. By looking at a chart you can quickly see whether a stock price is in a trading range or a trend.

What is the best way to learn technical analysis? ›

The best way to learn technical analysis is to gain a solid understanding of the core principles and then apply that knowledge via backtesting or paper trading. Thanks to the technology available today, many brokers and websites offer electronic platforms that offer simulated trading that resemble live markets.

What does Warren Buffett say about technical analysis? ›

Even multi-billionaire Warren Buffett is famously quoted as saying, "I realized that technical analysis didn't work when I turned the chart upside down and didn't get a different answer." But whether you understand technical analysis or not, it can be a valuable tool to help make investment decisions.

Do professional traders use technical analysis? ›

Technical analysis is not only used by technical traders. Many fundamental traders use fundamental analysis to determine whether to buy into a market, but having made that decision, then use technical analysis to pinpoint good, low-risk buy entry price levels.

How do you predict which stocks will go up? ›

Major Indicators that Predict Stock Price Movement
  1. Increase/Decrease in Mutual Fund Holding. ...
  2. Influence of FPI & FII on Stock Price Movement. ...
  3. Delivery Percentage in Stock Trading Volume. ...
  4. Increase/Decrease in Promoter Holding. ...
  5. Change in Business model/Promoters/Venturing into New Business.
Nov 1, 2021

Which indicator is the most accurate? ›

The STC indicator is a forward-looking, leading indicator, that generates faster, more accurate signals than earlier indicators, such as the MACD because it considers both time (cycles) and moving averages.

Is technical analysis enough for day trading? ›

In day trading, technical analysis is one of the most effective strategies for simplifying large amounts of data in order to ease the decision making process. Technical analysis operates under the premise that a stock's price movement accounts for all factors.

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