Technical Analysis

There are two main methods of analysing securities to make investment decisions: fundamental analysis and technical analysis. Fundamental analysis involves looking at the characteristics of the company to determine its market value. Technical analysis involves looking at the past and current price movements of the market. Technical analysts do not care about the market value of a company.

Underneath all the complicated tools and technical lingo, technical analysis is really about the study of supply and demand. Supply and demand is the main controller of the market direction, and can help predict the trend, and whether it will continue in the future. In other words, technical analysis attempts to understand the emotions of the traders in the market. There are many benefits and limitations of technical analysis. Understanding these will enable you to be a better trader or investor.

Technical analysts rely on the statistics generated by market activity: open price, close price, high price, low price, and volume. With these statistics, analysis can generate chart patterns, find technical indicators and oscillators. The securities past trading data may look like just a graph of moving bars. However, if you know what to look for and interpret it correctly, it can be a powerful to predict the security’s future movements.

There are three main assumptions made when using technical analysis:
  1. The market discounts everything.
  2. Price moves in trends.
  3. History tends to repeat itself.

The Market Discounts Everything

Fundamental analysts will argue that technical analysis only considers price movement, and ignores the fundamental information of a company:  revenue, earnings, assets, liabilities and growth. However, technical analysis assumes that all this information is already reflected in the price. That is, at any given time, the stock's price reflects everything that could affect the company's price movements. Since all this information is neatly included in the company's stock price, there is no need to analyse these factors separately. The only thing left to do is analyse the movement of the stock prices. In other words, analysing the supply and demand in the market.

Price Moves in Trends

Price movements tend to follow a trend. The means, if a trend has been established, there is a higher likelihood that the trend will continue in the same direction. The likelihood of the trend going in the opposite direction is lower. Most trading strategies are based on this assumption.

History Tends to Repeat Itself

If you look at a chart of a stock's price movements, you will notice that history tends to repeat itself. This is due to market psychology. Traders tend to consistently react  the same way to certain types of market data over time. You can look at a chart pattern from a stock 100 years ago, and still find a similar chart pattern for the same market conditions. 

Applications of Technical Analysis

Technical analysis can be used on any type of security with historical trading data: Stocks, futures, commodities, fixed-income securities, forex.  We will be looking at technical analysis for stocks only. However, keep in mind that it can be used for any security.