There are two prime ways to analyze a stock: fundamental and technical analysis. While one looks at using historical trading data to analyze price and volume movements, the other analyzes business results. Both, however, can be used to your advantage if you do the right research.
This blog will be your go-to beginner’s guide on what technical analysis is, the foundations of the analysis, how it differs from fundamental analysis, and some examples of the many indicators. Keep reading to find out how to implement technical analysis into your trading strategy.
Definition of Technical Analysis
In a fundamental sense, technical analysis is using a stock’s chart to forecast future price movement. While not always accurate, it can help traders make decisions on what to do with stocks. Technical analysis may be more often used in trades that involve short-term price movements, such as forex markets.
In a more, dare we say it, technical sense, technical analysis is a way to evaluate stocks by analyzing trends, such as price and volume.
Technical analysis uses charts to look for patterns and signals that may indicate whether to buy, hold or sell a stock. It is based on the historical trading history of the stock being analyzed.
The Three Assumptions of Technical Analysis
1. History Tends to Repeats Itself
Technical analysts follow the assumption that history repeats itself, so you can make predictions about what a stock’s price will do based on historical data. Chart patterns will show analysts how the price has changed over time to predict what may happen in the future.
2. Prices are Driven by Trends
Technical analysts follow the assumption that stock prices have short-term, medium-term, and long-term trends. According to this belief, prices will move in a trend, rather than random.
3. The Market Discounts
This is the belief that assumes the price already takes in the stock financials, economy and overall market health, so there is no need to analyze these like you would in fundamental analysis.
Fundamental v. Technical Analysis
As mentioned previously, technical analysis is the use of using charts, trends and historical price movements to make trading decisions.
Fundamental analysis is different because it is based on a company’s intrinsic value, what the stock is worth. This is based on the company’s financials, the economy, and market conditions. A fundamental analyst will look into things like earnings, expenses, liabilities, and more.
Read More: Beginner’s Guide to Fundamental Analysis
Basics of Technical Analysis
Types of Technical Analysis
Many traders tend to stick to two common types of technical analysis:
- Chart patterns
- Statistical indicators
Chart Patterns – As the name suggests, this uses charts to find out where prices are headed. More specifically, traders using chart pattern analysis will use support and resistance lines as indicators for where breakouts might occur. This type of analysis, like many other trading strategies, is based on predictions and may have underlying psychological factors that can help predict where price is moving.
Relative Strength Index (RSI)
Indicates whether price action is created by overselling or overbuying. Stocks are assigned a value from 0 to 100. Usually, a value of 70+ indicates a stock is overbought, while a value 30 and under indicates a stock is oversold.
Moving averages help show a trend more clearly using the average of prior stock price moments. There are two types:
- Simple Moving Averages (SMA): Sum of closing prices of the given time period, divided by the number of prices
- Exponential Moving Averages (EMA): Using a formula, weighs the more recent stock prices more, than the older prices for the given time range
Support and Resistance Levels
Support levels are a stock’s previous lows, and resistance levels are a stock’s previous highs. These levels can help determine if a stock is on a bullish or bearish path. For example, if a stock price is below the support line, it could mean a bearish trend. It’s important to look at both support and resistance lines since prices are usually between the lines.
Other Indicators and Oscillators
There are hundreds of different types of indicators using different types of formulas and calculations to help confirm patterns and trends. Some technical indicators are known as oscillators, which use two limits and are good for determining overbought/oversold stocks.
Some examples of indicators and oscillators include:
- Moving Average Convergence Divergence (MACD): Shows if the price movement and momentum is strengthening or weakening.
- Parabolic Stop and Reverse: Can help indicate potential reversals in price direction
- Stochastic Oscillator: Compares a closing price of a stock to a selected range of prices over time.
- Bollinger Bands®: Copyrighted by technical trader John Bollinger, this tool uses three lines (simple moving average and a positive standard deviation and negative standard deviation). The wider the band, the more volatile the stock.
Statistical Indicators – This is more of a mathematical approach to technical analysis that make use of indicators like moving averages, MACD, and Bollinger Bands. Like chart patterns, these indicators can be used on a heuristic basis to help you make faster, more reliable trading decisions.
Tips for Beginners in Technical Analysis
Here are a few tips to keep in mind when considering using technical analysis in your trading strategy, especially for beginners.
There are two distinct ways to approach technical analysis that can be used as a foundation once you become more familiar with it and add your own strategy concepts to it.
- Top-Down Approach starts with looking at the macroenvironment then working your way into the individual stock itself. This approach may be more beneficial for those of you utilizing a short-term strategy.
- Bottom-Up Approach The exact opposite of top-down approach where this time you’ll be analyzing the individual stock before anything else. This approach can be great for traders who are interested in using a long-term strategy
- Understand the fundamentals of technical analysis There is a lot that goes into technical analysis. It’s more than just using present data like business sales and revenue. Understanding chart patterns take time to fully grasp. In order to recognize and spot patterns quickly, you’ll need to see them over and over again.
Weaknesses of Technical Analysis
One limitation of technical analysis is accuracy. Of course, there is no one way to 100% be accurate 100% of the time when it comes to analyzing stocks. While you can make predictions based on history, a stock may or may not follow historical trends, such as unprecedented news.
Another limitation is two indicators saying different things—one might suggest a buy, the other may suggest a sell. Using a combination of indicators, volume, moving averages, and chart patterns is a way to best determine what to do when using technical analysis.
Technical analysis is just one of the ways you can analyze a stock. It is based on charting patterns and indicators to determine the best opportunity to buy and sell. Take the time to research all of the different types of indicators to see what first best for your trading strategy.
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