If you’re new to trading or thinking about starting to make your own trades, then it’s important to learn about technical analysis. Traders and investors use technical analysis to evaluate potential investments and spot opportunities to turn a profit based on historical trends and statistics from past trades. Technicians spend a lot of time studying trading charts to identify signals which could indicate that it’s time to buy or sell an asset. They often use some well-known patterns on price charts to identify buy and sell signals.
Technical analysis can be used in the study of stock charts, foreign exchange price trends, gold and other precious metals, and other assets.
Technical analysis versus other forms of analysis
To really understand what technical analysis is, it’s a good idea to know what it isn’t. For example, technical analysis differs greatly from fundamental analysis, which involves the use of metrics like earnings numbers to determine what a stock might be worth. Fundamental analysis of other assets is also possible using other metrics that help determine their intrinsic value. In stocks, the emphasis is on the health of the company being evaluated.
On the other hand, technical analysis uses trading patterns and various technical indicators like moving averages, volatility measurements, volumes and other historical data. Technical analysts try to predict where an asset’s price will go next by looking at where it has been in recent history. Instead of trying to gauge the health of a company, they try to identify patterns and signals on the trading chart.
Two other forms of investment analysis are top-down and bottom-up. These forms of analysis are not opposite of technical analysis the way fundamental analysis is. They are simply different ways of looking at and interpreting the same sets of data. Bottom-up analysis involves looking at stocks based on their own valuation and other merits. It doesn’t take into account broader economic cycles or other exterior factors. Instead, it involves a sort of tunnel vision with a laser focus on the individual stock.
Top-down analysis includes macroeconomic factors in addition to individual factors. Market and economic trends are considered even before individual factors when it comes to picking stocks. Traders who use a top-down approach to analysis may identify particular sectors or industries they want to invest in before taking a more granular view to look at individual stocks within those sectors or industries.
The history of technical analysis
Technical analysis has its roots in the Dow Theory, which was derived from hundreds of Wall Street Journal editorials written by Charles Dow in the late 1800s. The theory states that the market is in an uptrend if one of its averages moves higher than another recent high and is followed by a similar upward movement in another average.
For instance, the transportation sector is considered to be in an uptrend if the Dow Jones Industrial Average moves higher than its other recent high and then the Dow Jones Transportation Average does the same within a short time. A downtrend is indicated if both averages move below a recent low within a short period of time.
In addition to two averages confirming each other, volumes must also confirm downtrends and uptrends. Volumes should rise if the price is increasing and fall if the price is decreasing. The trend continues until there is an obvious reversal in the pattern.
The Dow Theory is based on the efficient markets hypothesis, which assumes that asset prices move based on all the information that’s available. The efficient markets hypothesis differs from behavioral movements in asset prices which cause them to move based on investor sentiment rather than anything concrete.
The benefits and shortcomings of technical analysis
Technical analysis offers many advantages, which is why so many traders include it in their strategies. Perhaps the most obvious benefit is that it enables you to see any security’s overall trend. You’re removing behavioral factors from the conversation, which helps you avoid having knee-jerk reactions to headlines or various events. Trends enable you to study the behavior of other traders without getting swept away by any particular event.
Technical analysis also helps you determine good entry and exit points for securities and enables you to see when an asset is close to a bottom or top. The ultimate goal in investing is to buy low and sell high. While it’s impossible to do this without a significant amount of luck, studying patterns and trends enables you to see when an asset is in the process of changing directions. This enables you to buy close to the bottom and sell close to the top, thus reducing your risk of losing money if executed and timed properly.
The more you learn about technical analysis and the longer you practice it, the faster you will get at identifying trends and making trades. Technical analysis also allows you to get a significant amount of information in a short amount of time. It can be used by short-term traders, those with a longer-term buy-and-hold strategy, and swing traders.
Of course, no trading strategy is perfect, so technical analysis does have its problems. For example, there are so many indicators to choose from that it can be difficult to know which one is signaling the correct upcoming pattern. The more experienced you become, the easier this will be to do, but the learning curve can be a bit steep. Some indicators may even produce conflicting signals. With experience, you learn to decipher which indicator is producing the most likely signal.
Technical analysis is also subject to personal biases. It can be tempting to look for patterns which agree with what you already believe about a security. In some ways, this can be a way of confirming your thesis. However, you may also simply filter out the indicators that disprove your thesis while choosing to follow the ones that do agree. Once again, experience is the key to this problem. The longer you practice, the more you will understand your own biases and tendencies.
The main components of technical analysis
The most basic theory behind technical analysis is that asset price movements are not random and instead move in patterns which can be identified and tend to repeat themselves over time. Since asset prices move according to patterns, past price changes can be used to predict where the price will go next. Technical analysis assumes that the market discounts everything, meaning fundamentals don’t need to be considered separately because they are already priced into an asset’s movements.
When performing technical analysis of any asset, traders look at several indicators:
- Moving averages – They help smooth out price trends by removing some of the volatility or noise from changes in price that occur somewhat more randomly or outside the overall pattern. Traders look at simple moving averages, which just look at the price over a set period of time like 200 days, and exponential moving averages, which weight more recent prices more heavily than earlier prices.
- Price trends – Moving averages enable traders to look at overall price trends. By looking at the 200-day moving average, technicians can see whether a security is generally moving up or down. Studying price trends can help traders buy closer to the bottom price and sell closer to the top.
- Support and resistance levels – Looking at the moving averages also enables traders to determine the support and resistance levels. Any break above a support level signals a bullish trend, while a break below a resistant level is a bearish signal.
- Volumes – Studying volumes shows how much trading action is occurring in a particular security. If there’s little activity, it means interest—both bullish and bearish—is lackluster. Traders are neither buying nor selling the security, which will make it difficult to get any money back out of it in the short term. It’s good to buy and hold some assets if you can wait long enough for interest to be rekindled, and hopefully the interest that returns is from buyers instead of sellers.
- Momentum – Stocks and other assets can have upward or downward momentum. If there’s upward momentum, it means the bulls are in control, and there’s a lot of buying occurring. Bears are in control of downward momentum, which means most traders are selling.
- Chart patterns – Technicians also study trading charts to identify common patterns so they can predict where the price will go next.
Common chart patterns
One of the hallmarks of technical analysis is the study of chart patterns. This component deserves its own section because of its complexity. Although technicians identify many different patterns, three of the most common are the “Cup with Handle” / “Cup without Handle,” “Double Bottom,” and “Flat Base.”
For a chart to be displaying a Cup with Handle, it must first have an uptrend with at least a 30% gain. This forms the left side of the cup. The strong uptrend is followed by a dip of 15% to 30% lasting at least seven weeks, which creates the inside of the cup. The dip is followed by an uptrend, but within that uptrend, there is a much smaller and briefer downtrend of only 10% to 12% with light volumes. The handle peaks within 15% of the high which marked the left side of the cup. In the case of a Cup without Handle, the pattern is the same, except without the brief dip on the back end or right side of the cup.
A Double Bottom is exactly as it sounds. There are two somewhat rounded dips in the price following a longer downtrend. The Double Bottom usually signals that the bearish trend is close to ending. The Double Top is the opposite of a Double Bottom with two tops signaling an upcoming downtrend. Usually the second top in a Double Top is a little lower than the first one.
Flat Bases can be a little trickier to tell apart from other chart patterns. While they do signal that the price is somewhat range-bound, it does go up and down a bit. Flat Bases follow an uptrend of at least 30% and have a depth of no more than 15%. The base must last at least five weeks, with the first down week in the base being the first week.
Chart technicians identify these patterns and others and use them to determine whether it’s time to buy or sell. We’ll talk more about individual patterns and what they mean in future articles in this series.
Putting technical analysis into practice
There are several strategies which can be followed for technical analysis. For example, traders may simply follow two moving averages and watch to see where or when they cross. If the 50-day moving average crosses over the 200-day average, it suggests an uptrend is underway, while the reverse is true if the 50-day crosses under the 200-day average. A buy signal is triggered in the case of an uptrend, while a sell signal is indicated if a downtrend is confirmed by a crossover.
No matter which strategy you use, you will need to filter out the securities which fit the patterns you are looking for. You will also need a brokerage account and trading platform which will enable you to identify patterns and then act upon what you see.
When choosing a brokerage account, look for one with the appropriate tools and the lowest possible fees. The higher the trading fees are, the less your profit will be when selling securities. Basic accounts are usually great for beginners, although if you advance to day trading, you will need a margin account and other tools. A margin account involves borrowing cash to buy securities.
You may even want to try your hand at trading in a demo account before you actually start investing real cash. Some trading accounts also offer free trials so you can try out their tools before starting to pay for the platform. Back-testing is also an important part of the process because it allows you to see how a strategy performed in the past before you start following it with capital. It’s also advisable to start with a small amount of capital first and scale up slowly as you gain experience and see if your strategies are turning a profit.
In the rest of this series, we will discuss each of the above topics more in depth.