What Is Technical Analysis?

Technical analysis is a practical method for evaluating statistical trends derived from trading activities, particularly price movements and trading volumes. Investors and traders use this technique not just to discover potential investment or trading opportunities, but also to make informed decisions in the dynamic world of financial markets.

Unlike fundamental analysis—which evaluates a security’s intrinsic value by examining financial data like earnings and sales—technical analysis focuses on price and volume patterns to forecast future price changes.

Key Takeaways

• Technical analysis helps assess price trends and patterns, identifying potential investment and trading opportunities.
• Proponents of technical analysis believe that past trading activities and price fluctuations can provide meaningful insights into a security’s potential future performance.
• This contrasts with fundamental analysis, which examines a company’s financial health instead of historical price patterns or stock movements.
• Charles Dow is credited with introducing technical analysis.

Understanding Technical Analysis

Technical analysis examines how supply and demand for a particular security affect its price changes, trading volumes, and implied volatility. It operates under the assumption that a security’s past price activity can help predict its future price movements when combined with appropriate trading or investing strategies.

This technique often uses various charting tools to create short-term trading signals. Additionally, technical analysis can enhance an analyst’s evaluation of a security’s strength or weakness in the broader market or a specific sector. Such information is valuable for determining a more accurate valuation of a security.

As it exists today, technical analysis has evolved significantly from the Dow Theory introduced by Charles Dow in the late 1800s. Researchers like William P. Hamilton, Robert Rhea, Edson Gould, and John Magee have made significant contributions, and over time, this field has expanded to include hundreds of chart patterns and indicators developed through years of market research. This evolution makes the audience feel part of a dynamic and ever-changing field.

How Technical Analysis Is Used

Professional analysts often employ technical analysis alongside other research methods. While retail traders might rely solely on price charts and statistical trends to make decisions, institutional analysts rarely rely on one analysis method. Instead, they use technical analysis as a supplement to fundamental analysis.

Technical analysis can be applied to any asset with historical trading data, including stocks, futures, commodities, bonds, and currencies. It is particularly popular in forex and commodities markets, where short-term price movements dominate. The power of technical analysis lies in its ability to predict price movements in virtually any tradable instrument influenced by supply and demand dynamics, giving traders and investors a sense of control and confidence.

While technical analysis predominantly focuses on price, some analysts also track other statistics, such as trading volume and open interest.

Technical Analysis Indicators

Over time, researchers have developed numerous patterns and indicators to support technical trading strategies. Some indicators are designed to highlight the current market trend, including areas of support and resistance. Others measure the strength of a trend and predict whether it will continue.

The most commonly used technical analysis tools include trendlines, channels, moving averages, and momentum indicators.

Technical analysts focus on the following types of indicators:

• Price Trends
• Chart Patterns
• Volume and Momentum Indicators
• Oscillators
• Moving Averages
• Support and Resistance Levels

The CMT Association plays a significant role in promoting technical analysis. It offers the most extensive global professional network of chartered market technicians (CMTs). The CMT designation requires passing three exams covering a comprehensive range of technical analysis tools.

Core Assumptions of Technical Analysis

Technical analysis aims to uncover market sentiment through price trends and patterns. The foundational principles of this method stem from Charles Dow’s editorials on the Dow Theory. Two of his assumptions remain relevant today and form the basis of technical analysis:

• Markets Reflect All Information: Technical analysts believe everything influencing a security’s price, from company fundamentals to market conditions and investor psychology, is already incorporated in the price. This is similar to the Efficient Markets Hypothesis (EMH).
• Prices Move in Trends: Even in seemingly random movements, stock prices exhibit trends, which are more likely to continue than change unpredictably. This belief underlies most technical trading strategies.

These assumptions have been extended into three fundamental principles widely accepted by technical analysts:

• The Market Discounts Everything: According to this principle, all factors—economic, political, or psychological—affecting a security’s price are already reflected in its market price. Technical analysts, therefore, focus solely on price movements.
• Price Trends: A stock’s price is more likely to follow an existing trend than to deviate. Technical traders base their strategies on this belief.
• History Repeats Itself: Price patterns tend to recur due to predictable market psychology driven by emotions like fear and greed. Analysts rely on historical chart patterns to predict future trends.

Fundamental Analysis vs. Technical Analysis

The two significant schools of thought—fundamental and technical analysis—take opposite approaches to researching the markets. Both aim to forecast stock price movements based on different assumptions and methodologies. Both have their advocates and critics.

Fundamental Analysis

This method determines a security’s intrinsic value by assessing a company’s financials, economic factors, and industry trends. Fundamental analysts focus on earnings, expenses, assets, and liabilities to evaluate a stock’s value.

Technical Analysis

In contrast, technical analysis disregards fundamental data. Instead, it assumes all known information is already factored into the price. Analysts rely solely on price charts and volume patterns to forecast future price movements.

Limitations of Technical Analysis

Efficient Market Hypothesis (EMH): Some analysts and researchers argue that technical analysis could be more effective, as EMH suggests that no helpful information can be derived from historical price and volume data. The weak and semi-strong forms of EMH suggest that neither technical nor fundamental analysis provides actionable information.

Price Patterns Aren’t Perfect: Another criticism is that historical price patterns don’t exactly repeat themselves, and thus, studying them may be of limited value. Some believe prices follow a random walk, making technical analysis less reliable.

Self-Fulfilling Prophecies: Critics argue that technical analysis can lead to self-fulfilling prophecies. For example, suppose enough traders place stop-loss orders based on a specific moving average. In that case, security may drop prices as predicted simply because traders followed the same signal. However, this group of traders can only influence short-term price movements.

Key Assumptions of Technical Analysts

Professional technical analysts typically rely on three core assumptions:

• The Market Reflects All Information: The stock’s price already reflects all fundamental and technical factors.
• Price Trends Persist: Prices will likely follow established trends, regardless of the time frame.
• History Repeats Itself: Market psychology drives price patterns, and these patterns tend to repeat.

How to Learn Technical Analysis

The first step to mastering technical analysis is to understand the markets, stocks, and financial principles. This can be done through books, online courses, and formal classes. Once you have the basics, you can learn about technical analysis.

Final Thoughts

Technical analysis is a widely used technique for analyzing securities’ price and volume data to predict future price movements. By applying various technical indicators to charts, traders and investors can make informed decisions about when to buy and sell.