Technical analysis is a methodology for forecasting the direction of prices of a given financial market through the study of past market data, primarily price and volume. Behavioral economics and quantitative analysis use many of the same tools of technical analysis, which, being an aspect of active management, stands in contradiction to much of modern portfolio theory. The efficacy of both technical and fundamental analysis is disputed by the efficient-market hypothesis which states that stock market prices are essentially unpredictable.
While fundamental analysts examine earnings, dividends, new products, research, etc, technicians employ many methods, tools and techniques as well as the use of charts. Using charts, technical analysts seek to identify price patterns and market trends in financial markets and attempt to exploit those patterns.
Technicians using charts often search for price chart patterns, such as the well-known head and shoulders or double top/bottom reversal patterns, study technical indicators, moving averages, and look for forms such as lines of support, resistance, channels, and more specific formations such as flags, pennants, balance days and cup and handle patterns.
Technical analysts also widely use market indicators of many sorts, some of which are mathematical transformations of price. These indicators are used to help assess whether an asset is trending, and if it is, the probability of its direction and of continuation. Technicians also look for relationships between price/volume indices and market indicators. Examples include the moving average, relative strength index, and MACD. Other avenues of study include correlations between changes in Options (implied volatility) and put/call ratios with price. Also important are sentiment indicators such as Put/Call ratios, bull/bear ratios, short interest, Implied Volatility, etc.
Uncovering the trends is what technical indicators are designed to do, although neither technical nor fundamental indicators are perfect. Some traders use technical or fundamental analysis exclusively, while others use both types to make trading decisions.
General Principles of Technical Analysis
A cornerstone principle of technical analysis is that a market’s price reflects all relevant information, so their analysis looks at the history of a security’s trading pattern rather than external drivers such as economic, fundamental and news events. Therefore, price action tends to repeat itself due to investors collectively tending toward patterned behavior – hence technical analysis focuses on identifiable trends and conditions.
Market action discounts everything
Based on the premise that all relevant information is already reflected by prices, technical analysts believe it is important to understand what investors think of that information, known and perceived.
Prices move in trends
Technical analysts believe that prices trend directionally, i.e., up, down, or sideways (flat) or some combination. The basic definition of a price trend was originally put forward by Dow Theory.
History tends to repeat itself
Technical analysts believe that investors collectively repeat the behavior of the investors that preceded them. To a technician, the emotions in the market may be irrational, but they exist. Because investor behavior repeats itself so often, technicians believe that recognizable (and predictable) price patterns will develop on a chart. Recognition of these patterns can allow the technician to select trades that have a higher probability of success.
Check out the Trading Fundamentals course and the Technical Toolkit Videos for more detailed insight on how to use technical analysis in your trading.
