Technical analysis is the study of past market data, through the use of charts, to predict a security’s future price. Unlike fundamental analysis, technical analysis does not focus on studying a company’s financial statements and earnings to determine a company’s intrinsic value, or its actual worth. Instead, technical analysts use charts and technical indicators to identify patterns that can suggest future price movements. They disregard the underlying data that causes the price movements and focus on what the market is valuing the stock at.
The charts themselves do not cause market action, but rather, they indicate the actions of the marketplace and what has already happened. Charts reflect trades by all market participants, such as buyers, sellers, and even insiders. Analyzing charts means that you are analyzing the behavior of all these traders. Each price on the charts reflects the actions or lack of actions by all the traders in the market.
Technical analysis can be applied to any security with historical trading data. This includes stocks, futures and commodities, fixed-income insecurities, forex and more. Although we will usually analyze stocks in our examples, keep in mind that these concepts can also be used on other types of securities.
For further clarifications, see how technical analysis is different from fundamental analysis.
Technical Analysis Assumptions
In author Tony Plummer’s book, The Psychology of Technical Analysis, he paraphrases a quote by Oscar Wilde by stating, “A technical analyst knows the price of everything, but the value of nothing.” Technicians are more concerned with the “what” rather than the “why.”
The study of technical analysis is based on three main assumptions:
1) The market discounts everything.
2) Prices move in trends.
3) History tends to repeats itself.
1) The market discounts everything
Technical analysis is based on the Dow Theory that the market discounts everything and that all past, current, and even future information, is reflected in the security’s price. This information includes fundamental factors, psychological factors, and any recent news about the company.
Technicians believe that if everything is already reflected in the market price, then it is only necessary to study price charts. They believe that by studying price charts, you are indirectly studying the fundamentals of a company, as well as the psychology of the marketplace for that company. For example, if prices are going up, they assume that demand must be exceeding supply, indicating that the fundamentals are bullish. If prices are falling, they assume that supply must be exceeding demand, indicating that the fundamentals are bearish.
Since the market discounts everything, technicians ignore the factors that cause price movements and exclusively study price history and volume data.
2) Prices Move in Trends
Technicians believe that prices are not always random and tend to follow trends, such as an uptrend or downtrend. Most technical trading strategies are based on the assumption that once a trend has been established, the future price movement is more likely to be in the same direction as the trend than to be against it. Since technical analysis can be applied to many different time frames, it is possible to identify both short-term and long-term trends.
3) History tends to repeat itself
A study of history shows that set patterns tend to repeat themselves over long periods. The repetitive nature of price movements is attributed to market psychology, meaning traders tend to have a consistent reaction to similar market stimuli over time. Since investor behavior repeats itself so often, technicians believe that predictable price patterns will develop on charts.
By relying on price patterns, we can identify optimal trade entry and exit points. Recognizing trends in their early stages allows us to trade favorably in the direction of those trends until it shows signs of reversing.
Now that you have a basic understanding of the technical analysis methodology of trading, it is imperative to continue studying hard and learn about the different types of technical indicators.