What is technical analysis?
The technical analysis definition is a trading tool and method of analysing financial markets and choosing investment strategies. Along with fundamental analysis, it is one of the two main ways to analyse markets and involves looking at past market performances in terms of price movements, volume, moving averages and various outcome statistics.
Where have you heard about technical analysis?
You may have come across the investment reference book by John J. Murphy titled ‘Technical Analysis of the Financial Market’ or heard the term ‘chartists’, which is a widely used term to refer to advocates of the method. The ‘Chartists’ label derives from the fact that technicians use and refer to a lot of charts when explaining their analysis.
Technical analysis is also often referred to in the form ‘FOREX technical analysis’with the FOREX in FOREX technical analysis referring to the foreign exchange market. As the FOREX is a 24-hour market, FOREX technical analysisis deemed to be a significant source of forecast statistics as there is so much data to analyse to help gauge future price activity.
What you need to know about technical analysis…
Technical analysis differs to fundamental analysis as it does not attempt to measure the intrinsic value of a security, but rather it identifies different market patterns to use as a basis for investment decisions. Technical analysis takes many different forms with some technical analysts using technical indicators and oscillators, some relying on chart patterns and some using a combination of the two. The only thing that matters in technical analysis is trading data from the past; analysts do not consider the value of a stock when predicting future price movements.
Main assumptions of technical analysis
In order to predict future price movements to then make strategic investment decisions, technical analysis makes the following assumptions:
- The market discounts everything
- Price changes are not random, but rather price moves in trends
- Enough people seeing the same patterns may force predictions to occur
- History often repeats itself
In regard to the assumption that market discounts everything, this theory is based on the fact that technical analysts believe that broad market factors and market psychology are already priced into the stock. This theory is often criticised by various experts, as well as the Efficient Market Hypothesis as it considers price movements only, ignoring other fundamental factors.
The second assumption that price changes are not random derives from the belief that prices move in trends, whether that’s over a short-term basis, medium-term basis or long-term basis. Technical trading strategies are mostly based on the assumption that stock prices will likely repeat a past trend. The self-fulfilling prophecy theory that assumes predictions sometimes occur as a result of enough people identifying the same patterns can be beneficial if everyone is buying into the market, but very problematic if it means everyone tries to exit the market at the same time.
Finally, the idea that history tends to repeat itself relies on market psychology, which often proves to be very predictable when considering certain emotions such as excitement and fear. Chart patterns have been analysed for over 100 years to understand trends surrounding the relationship between emotions and market movements.
As mentioned above, technical analysis often involves the use of technical indicatorsand oscillators. This approach is statistical rather than subjective and involves analysing market trends, flow, volatility and momentum to help analysts confirm the quality of chart patterns.
Technical indicators come in two forms: leading and lagging. The former aims to predict future price movements and help to identify price breakouts and breakdowns, whilst the latter actually follows and confirms price movements. Breaking them down further, technical indicatorsare either oscillators and generally bound within a range or non-bounded, which though less common can help to show strengths and weaknesses within trends.
Examples of technical indicators include:
- Trend indicators (lagging), which measure a trend’s strength and direction. The trend is considered bullish when prices move above average and bearish when prices move below average. Specific examples include moving averages and moving average convergence divergence (MACD)
- Momentum indicators (leading), which help to identify the speed and volume of price movements by comparing prices over time. Specific examples include stochastic oscillators and relative strength index (RSI)
- Volatility indicators (lagging), which measure the rate of price movements based on the highest and lowest historical prices. Specific examples include Bollinger bands and standard deviation
- Volume indicators (leading and lagging), which measure a trend’s strength and direction based on some averaging or smoothing of raw volume. Specific examples include the Chaikin oscillator and on-balance volume (OBV)
Chart patterns play a huge role in technical analysis of stocks, helping analysts to identify trading signals and future price movements. This area within technical analysis relies heavily on the assumption that history repeats itself, with the belief that chart patterns reoccur and produce the same outcomes. Most chart patterns are either reversals or continuations, with the former signalling that the trend will reverse once the pattern is complete and the latter signalling that the trend will continue once the pattern completes.
The Head and Shoulders chart pattern (see below, source Wikipedia) indicates that the trend is likely to reverse after it’s complete. The key characteristics of this pattern are three peaks with the middle peak being the highest peak and the other two peaks sitting beside them at a lower but roughly equal height.
Other types of chart patterns include the Cup and Handle, which is a bullish continuation pattern and the Double Top or Double Bottom, which are two of the most reliable chart patterns making them exceptionally popular amongst traders. The Double Top and Bottom chart patterns (see example of the Double Top below, source Wikipedia) are easy to recognise and signal the start of a trend reversal.
Other types of chart patterns include Triangles, Flags and Pennants, Wedges, Triple Tops and Bottoms, Rounding Bottoms and Gaps.
How technical analysis is used
By using various chart patterns and calculations, technical analysts can spot market trends and predict future movements. Technical analysis of stocks is most commonly applied to price changes, but some analysts use technical analysis to track trading volume and other market measurements. The main belief in technical analysis of stocksis that historical prices and market psychology are huge indicators of whether stock prices will soon rise or fall.
Technical analysis is not without criticism, with many analysts deeming it a waste of time and effort instead relying on fundamental analysis. Since fundamental analysis measures a stock’s intrinsic value, it takes into account the overall economy, industry conditions and the state of a company’s management and financial situation. Technical analysis is deemed by critics to be wishful thinking. As mentioned above, the criticism surrounding technical analysis is often a result of the Efficient Market Hypothesis, which states that asset prices already fully reflect past trading information.
Since technical analysis and fundamental analysis lie on either end of the spectrum, it is recommended that traders carry out extensive research before deciding which approach to adopt. If adopting technical analysis, it is important to choose the most appropriate strategy or trading system. Examples of technical analysis strategies include the top-down approach, where traders screen stocks of certain criteria; and the bottom-up approach, where traders analyse stocks with interesting potential entry and exit points.
Find out more about technical analysis…
Our online glossary contains many different definitions of financial terms, including those relating to technical analysis. To find out more about specific related terms, please refer to our definitions of technical indicators and fundamental analysis.