Technical Analysis: What It Is

Zarith Sofea · 08 Feb 10K Views

Technical analysis is a strategic approach used in trading to assess investments and pinpoint potential trading prospects. It involves examining statistical trends derived from trading activities, specifically analyzing factors like price fluctuations and trading volume. In contrast to fundamental analysis, which assesses a security's value based on business performance indicators such as sales and earnings, technical analysis concentrates on the examination of price and volume patterns.

Understanding Technical Analysis

Technical analysis tools are employed to analyze how the interplay of supply and demand influences changes in the price, volume, and implied volatility of a security. This methodology operates on the premise that studying a security's past trading activity and price fluctuations can serve as valuable indicators for predicting its future price movements when combined with appropriate trading or investing rules.

While commonly utilized to generate short-term trading signals through various charting tools, technical analysis also enhances the assessment of a security's strength or weakness relative to the broader market or a specific sector. This information aids analysts in refining their overall valuation estimates.

The roots of modern technical analysis trace back to Charles Dow and the Dow Theory, introduced in the late 1800s. Subsequent contributions from notable researchers like William P. Hamilton, Robert Rhea, Edson Gould, and John Magee further expanded on Dow Theory concepts, establishing a solid foundation. In contemporary times, technical analysis has evolved, incorporating numerous patterns and signals developed over years of research.

Using Technical Analysis

Professional analysts frequently integrate technical analysis with other research methodologies. While retail traders might base decisions solely on price charts and related statistics, equity analysts typically broaden their research scope beyond just fundamental or technical analysis.

Technical analysis is adaptable and can be employed on any tradable instrument with available historical trading data, encompassing stocks, futures, commodities, fixed-income securities, currencies, and other financial instruments. It is notably more widespread in commodities and forex markets, where there is a focus on short-term price movements.

The primary objective of technical analysis is to predict the price movements of virtually any tradable instrument influenced by the interplay of supply and demand forces. This extends to various assets such as stocks, bonds, futures, and currency pairs. Some perceive technical analysis as essentially the examination of supply and demand dynamics as reflected in a security's market price movements.

While the focus of technical analysis is commonly on price changes, certain analysts also consider factors beyond price, such as trading volume or open interest figures.

Technical Analysis Indicators

In the realm of financial markets, a multitude of patterns and signals have been meticulously crafted by researchers to bolster the practice of technical analysis in trading. Within this framework, analysts have devised various trading systems aimed at predicting and capitalizing on price movements.

Numerous indicators serve distinct purposes, with some honing in on discerning the prevailing market trend, pinpointing critical support and resistance zones. Others are designed to gauge the strength of a trend and assess its likelihood of persistence. Among the commonly employed technical tools are trendlines, channels, moving averages, and momentum indicators.

In broad strokes, technical analysts categorize indicators into the following key types:

Price Trends

Chart Patterns

Volume and Momentum Indicators

Oscillators

Moving Averages

Support and Resistance Levels

This array of indicators and patterns collectively equips analysts with a comprehensive toolkit to analyze market dynamics and make informed trading decisions.

Technical Analysis vs. Fundamental Analysis

Fundamental analysis and technical analysis represent contrasting schools of thought in market analysis, each with its unique approach. Both methodologies are employed for researching and predicting future stock price trends, and like any investment strategy, they have both proponents and critics.

Fundamental analysis involves assessing securities by aiming to gauge the intrinsic value of a stock. Analysts employing this method scrutinize various factors, ranging from overall economic and industry conditions to the financial health and management practices of companies. Earnings, expenses, assets, and liabilities are among the key parameters considered by fundamental analysts.

In contrast, technical analysis diverges from fundamental analysis as it relies solely on the stock's price and volume as inputs. The underlying assumption is that all known fundamentals are already reflected in the stock price, obviating the need for close attention to these fundamentals. Technical analysts eschew attempts to measure a security's intrinsic value; instead, they utilize stock charts to identify patterns and trends that indicate potential future movements in stock prices.

Limitations of Technical Analysis

Some analysts and academic researchers argue that the Efficient Market Hypothesis (EMH) implies that historical price and volume data do not contain actionable information. This perspective extends to the belief that business fundamentals should also not offer actionable insights. These viewpoints are categorized as the weak form and semi-strong form of the EMH.

Another critique of technical analysis stems from the assertion that history does not precisely repeat itself, rendering the study of price patterns of questionable significance and dismissible. Prices, it is argued, are more accurately modeled by assuming a random walk.

A third objection to technical analysis posits that its success in certain instances is attributed to being a self-fulfilling prophecy. For instance, some technical traders set stop-loss orders below a company's 200-day moving average. If a substantial number of traders adopt this strategy and the stock reaches the specified price, a surge in sell orders will occur, driving the stock down and validating the anticipated movement by traders.

Chartered Market Technician (CMT)

The CMT Association, a leading organization for professional analysts specializing in technical analysis globally, boasts the most extensive group of chartered or certified analysts in this field. Achieving the Chartered Market Technician (CMT) designation involves passing three levels of exams, providing a comprehensive examination of various technical analysis tools.

In a recent development, the association has decided to exempt Certified Financial Analyst (CFA) charterholders from taking Level 1 of the CMT exam. This policy change underscores the synergy between the two disciplines and how they complement each other effectively.


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