There are two main ways to analyze a stock: fundamental and technical analysis.
This week, we’re touching on technical analysis to give you a 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.
Definition of Technical Analysis
In a basic 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.
In a more, dare we say it, technical sense, technical analysis is “a trading discipline employed to evaluate investments and identify trading opportunities by analyzing statistical trends gathered from trading activity, such as price movement and volume,” according to Investopedia.
Technical analysis uses charts to look for patterns and signals that may signal 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 historically. 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, 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.
Basics of Technical Analysis
Relative Strength Index (RSI)
Indicates whether price action is created by over 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.
Weaknesses of Technical Analysis
One limitation of technical analysis is the 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 way 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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