What is Technical Analysis?
Technical analysis involves the study of historical price and volume data to predict future outcomes. It is based on principles introduced by Charles Dow in the late 1800s. By identifying patterns and making forecasts, the technical analysis aims to understand and anticipate future price movements. The concept of technical analysis is actually quite simple.
In technical analysis, the past performance of a stock or security is studied to identify trends and patterns, which helps predict its future behaviour. This analysis can be applied to various traded securities such as futures, commodities, currencies, bonds, and stocks, as long as historical data is available.
Use of Technical Analysis
Retail traders mostly rely on price charts and associated statistics when making trading decisions. However, professional equity analysts typically consider a combination of both technical and fundamental analysis.
It’s important to note that technical analysis can be applied to any security that has historical trading data available, including commodities, currencies, and stocks. In fact, technical analysis is commonly used in commodity and foreign exchange (FX) markets, where traders focus on short-term price movements.
How to Do a Technical Analysis of Stocks
Technical analysis can be taken in a straightforward manner. You select a particular stock and study the patterns of price changes over a specific period to assess its potential as a future investment. However, practical implementation can be complicated in the beginning.
Before jumping into technical analysis, it’s important to know about two fundamental components:
- The Basic principles and 2. Key aspects of a stock. Understanding these elements lays the foundation for conducting effective technical analysis.
1. The Basic Principles of Technical Analysis
Charles Dow, at the end of the 19th century, contributed significantly to the theory of technical analysis. “The Dow Theory” is made of a comprehensive framework for understanding stock market trends and forms the basis of technical analysis. Several key principles derived from the Dow Theory include:
Market Discount Everything
The price of security fundamentally incorporates all available information that can impact the market. This means that factors such as a company’s financial position or the overall economy are already reflected in the market price. As a result, analysing a stock mainly based on its financial information or macroeconomic factors becomes futile since the market has already taken these aspects into consideration.
The Market has Trend
The stock market generally moves in three main trends: the primary trend (long-term), the secondary trend (intermediate-term), and minor trends (short-term fluctuations). The primary trend, which extends over a substantial duration, can be either bullish (upward) or bearish (downward).
History repeats itself
The behaviour of investors and traders tends to express patterns that repeat over time. The actions and habits of past investors often remerge in current and future investors. It is these recurring traders’ behaviours that give rise to price trends and enable a T.A. to be effective.
2. Key Aspects of a Stock
In technical analysis, the process is required to identify trends, but what exactly are these trends referring to? The trends being observed are primarily related to the price movement of a stock or security.
When analysing a stock, many crucial factors can be examined by studying a stock chart. This chart provides valuable information for conducting technical analysis and evaluating the stock’s performance.
- Market price
- Open high/open low
- Closing high/closing low
- 52-week high/low
Moreover, online platforms that provide stock charts usually offer customization options, allowing users to select the desired timeframe for analysis.
Whether it’s a week, month, 5-minute, 1- hour, or any other specific duration, users can customize the chart to view the stock’s performance within their chosen timeframe. This flexibility enables investors to focus on the specific period they find most relevant for their analysis.
Identifying Trends with Technical Analysis
Once you have knowledge of the principles of technical analysis and are familiar with the key components of a stock chart to focus on, the next step is to identify trend indicators.
This process involves examining the selected timeframe on the chart and searching for patterns or trends that may be present. By analysing these patterns, you can gain insights into the potential future direction of the stock’s price movement.
To identify Trend some indicator that helps traders are:
- Patterns: Technical analysis involves identifying any distinct and clear patterns that appear on a stock chart. These patterns can include recognizable formations such as head and shoulders, double tops or bottoms, triangles, or trend lines.
- Cycles: In technical analysis, cycles refer to specific periods of time during which a stock price trends in a particular direction before changing its trajectory. Understanding these cycles can help predict future price movements and identify the right entry or exit points in the market.
- Support: represent price levels on a stock chart where the stock has historically experienced increased buying activity.
- Resistance: Resistance levels are price levels on a stock chart that have historically caused the stock price to face significant selling pressure.
Technical analysis is a method used to predict future price movements in financial markets by analysing historical price and volume data. It is based on the belief that market trends repeat themselves and that past price patterns can provide insights into future price movements.
By studying stock charts and using various tools and indicators, technical analysts identify patterns, trends, and key levels of support and resistance. These analysts aim to make informed trading decisions based on the assumption that historical price behaviour can indicate potential future price behaviour.
Technical Analysis is a wide subject that includes price, trends, indicators, and different chart patterns, indicators, time frames, different theories i.e. Elliot wave, Dow Theory, Gann Theory etc., and many more concepts are there. You need to find your own comfort with strategy and should only focus on any one or two concepts because trading psychology is the key to winning the market, not technical analysis.