Technical analysis may appear complicated on the surface, but it boils down to an analysis of supply and demand in the market to determine where the price trend is headed. In other words, technical analysis attempts to understand the market sentiment behind price trends rather than analyzing a security’s fundamental attributes. If you understand the benefits and limitations of technical analysis, it can give you a new set of tools or skills that will enable you to be a better trader or investor over the long-term.
There are two primary methods used to analyze securities and make investment decisions: fundamental analysis and technical 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 is a method of evaluating securities that involves a statistical analysis of market activity, such as price and volume. Technical analysts do not attempt to measure a security’s intrinsic value, but rather, use charts and other tools to identify patterns that can be used as a basis for investment decisions.
Unlike fundamental analysts, technical analysts don’t concern themselves with a stock’s valuation – the only thing that matters are past trading data and what information the data might provide about future price movements.
Technical analysis is based on three assumptions:
- The market discounts everything.
- Price moves in trends.
- History tends to repeat itself.
Trends aren’t always easy to spot because prices almost never move in straight lines. Rather, prices tend to move in a series of highs and lows over time. In technical analysis, it is the overall direction of these highs and lows that constitute a trend. An uptrend is classified as a series of higher highs and higher lows, while a downtrend consists of lower lows and lower highs.
A channel consists of two trendlines that act as strong areas of support and resistance with the price bouncing around between them. The upper trendline consists of a series of highs, while the lower trendline consists of a series of lows. A channel can slope upward, downward, or sideways, but regardless of the direction, the interpretation is always the same. Traders expect the price to trade between the support and resistance trendlines until it breaks out beyond one of the two levels, in which case traders can expect a sharp move in the direction of the breakout. Along with clearly displaying the trend, channels are used to illustrate important areas of support and resistance for the stock price.
It is important to identify and understand trends so that you can trade with rather than against them. Two important sayings in technical analysis are “the trend is your friend” and “don’t buck the trend”, illustrating how important trend analysis is for technical traders.
- Technical analysis relies on the assumption
that all information is already reflected in the price of a security, which
means that analysis of that price is all that matters. By looking at price
patterns and statistics, technical analysts try to gauge the market’s overall
sentiment and determine where prices may be headed.
- Technical analysis is a method of evaluating
securities by analyzing market activity. It’s based on the assumption that the
market discounts everything, price moves in trends, and history tends to repeat
- Technical analysts believe that all
information needed to analyze a stock can be found in its price charts.
- Technical analysts tend to take a short-term
approach to trading.
- Critics of technical analysis tend to focus on
the Efficient Market Hypothesis, which states that the market price is always
correct, which makes historical analysis useless.
- Trends are the most important concept in
technical analysis and may consist of uptrends, downtrends, and sideways
- Trendlines are simply charting techniques
whereby a line is added to a chart to represent a trend.
- Channels are two parallel trendlines that act
as strong areas of support and resistance over time.
- Support is the price level where a stock or
market seldom falls, while resistance is the price level where a stock market
- Volume is the number of shares of contracts
that trade over a given period, with higher volume representing more activity.
- Charts are a graphical representation of a
series of prices over a set timeframe.
- The time scale refers to the range of dates at
the bottom of the chart, which can vary from seconds to decades. The most frequently used time scales are
intraday, daily, weekly, monthly, quarterly, and annually.
- The price scale is on the right-side of the
chart and shows a stock’s price over time. These prices can either be linear or
- There are four types of charts used by traders
and investors, including: line charts, bar charts, candlestick charts, and
point and figure charts.
- Chart patterns are distinct formations on a
stock chart that create a trading signal or a sign of future price movements.
These can be either reversals or continuations.
- A head and shoulders pattern is a reversal
pattern that signals that a security is likely to move against its previous
- A cup and handle pattern is a bullish
continuation pattern in which an uptrend has paused but is poised to continue
- Double tops and double bottoms are formed
after a sustained trend and signal that the trend is about to reverse.
- A triangle is a chart pattern created by
drawing trend lines along price ranges that get narrower over time. The two
most common types of ascending and descending triangles.
- Flags and pennants are short-term continuation
patterns that form when there’s a sharp price movement followed by a sideways
- Wedges are chart patterns that can be a
continuation or reversal depending on their design.
- Gaps are empty spaces that occur in charts
between trading periods.
- Triple tops and triple bottoms are reversal
patterns that occur when the price movement tests a level of support or
resistance three times.
- Rounding bottoms are long-term reversal
patterns that signal a shift from a downward trend to an upward trend.
- Moving averages are the average price of a
security over a given period of time. These can be simple, linear, or
exponential in their calculation.
- Moving averages help traders smooth out the noise
that’s common found in day-to-day price movements to give them a clearer
picture of the trend.
- Indicators are statistical calculations based
on the price or volume of a security that measures things like money flow,
trends, volatility, and momentum. They can be either leading or lagging in
- The accumulation/distribution line is a volume
indicator that measures the ratio of buying to selling in a security.
- The average directional index (ADX) is a trend
indicator that measures the strength of the current trend.
- The Aroon indicator is a trend indicator that
measures whether a security is in an uptrend or downtrend and the magnitude of
- The Aroon oscillator plots the difference
between the Aroon up and Aroon down lines by subtracting them.
- The moving average convergence divergence
(MACD) measures a security’s momentum using two exponential moving averages.
- The relative strength index (RSI) helps
measures overbought or oversold conditions.
- The on-balance volume (OBV) indicator helps
traders gauge volume changes.
- The stochastic oscillator compares a
security’s closing prices to its price range over a given period of time.
The idea of a trend is perhaps the most important concept in technical analysis. The meaning in finance isn’t all that different from the general definition of the term – a trend is really nothing more than the general direction in which a security or market is headed.