Technical analysis seeks to predict future market behavior by examining historical market data.
Technical analysis operates under three assumptions: the market discounts everything, price moves in trends, and history tends to repeat itself.
Traders typically use fundamental analysis to pick stocks and technical analysis to time their trades.
Understanding technical analysis
Technical analysis is a strategy used to predict future stock prices by studying historical trading data— primarily price and volume. This technique can be applied to a number of securities, including stocks, futures, commodities, and fixed-income markets.
Joseph de la Vega adopted early technical analysis techniques as far back as the 17th century to predict Dutch markets. However, the technical analysis theory as we know it was first introduced by Charles Dow in the late 1800s with the Dow Theory.In today's trading, technical analysis uses hundreds of patterns and signals that have been developed through years of insight and research.
Assumptions of technical analysis
Technical analysis is based on three underlying assumptions:
1. The market discounts everything
Technical analysts believe that a security's price already reflects all publicly available information, including the company's fundamentals and broad market factors.
2. Price moves in trends
From technical traders' perspectives, the price movement will exhibit certain trends and patterns.
3. History tends to repeat itself
The repetitive characteristic of price movements is often attributed to market psychology as investors tend to act similarly in fear or excitement.
Technical analysis tools
Hundreds of patterns and signals have been developed through years, making technical analysis more practical and systematic.
In general, technical analysts look at the following broad types of indicators:
Volume and momentum indicators
Support and resistance levels
The technical indicators listed above are usually used in combination to recognize the potential trading opportunities.
Technical analysis vs. fundamental analysis
Fundamental analysis and technical analysis are commonly recognized as two different investing styles:
Fundamental analysts seek to figure out the stock's intrinsic value by studying everything from the overall economy and industry conditions to companies' financial state and management. On the other hand, technical analysts try to evaluate the demand and supply of securities and focus on the historical data of stocks' price and volume.
Fundamental analysis studies financial data (revenues, expenses, assets, liabilities, etc.) and analyzes fundamental indicators such as Return on Equity, Price/Earnings ratio, and Debt/Asset ratio. Meanwhile, technical analysis may look into charts as well as numerous technical indicators such as moving average (MA), rate of change (ROC), moving average convergence divergence (MACD).
Fundamental analysis is more suitable for long-term investments, while technical analysis predicts short-term market movements better.
You may have heard that value investors commonly use fundamental analysis while only speculators use technical analysis. This is a complete misconception.
As a matter of fact, in actual market trading, many professional traders use the two together. Fundamental analysis is usually used to pick stocks, whereas technical analysis is used to find a good, low-risk entry or exit point.