Technical Analysis

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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. Unlike fundamental analysis, which attempts to evaluate a security's value based on business results such as sales and earnings, technical analysis focuses on the study of price and volume. Technical analysis tools are used to scrutinize the ways supply and demand for a security will affect changes in price, volume, and implied volatility. Technical analysis is often used to generate short- term trading signals from various charting tools, but can also help improve the evaluation of a security's strength or weakness relative to the broader market or one of its sectors. This information helps analysts improve their overall valuation estimate.

Technical analysis as we know it today was first introduced by Charles Dow and the Dow Theory in the late 1800s. 1  Several noteworthy researchers including William P. Hamilton, Robert Rhea, Edson Gould, and John Magee further contributed to Dow Theory concepts helping to form its basis. In modern day, technical analysis has evolved to included hundreds of patterns and signals developed through years of research.

Role of technical analysis in market

Technical analysis attempts to forecast the price movement of virtually any tradable instrument that is generally subject to forces of supply and demand, including stocks, bonds, futures, and currency pairs.

Across the industry, there are hundreds of patterns and signals that have been developed by researchers to support technical analysis trading. Technical analysts have also developed numerous types of trading systems to help them forecast and trade on price movements. Some indicators are focused primarily on identifying the current market trend, including support and resistance areas, while others are focused on determining the strength of a trend and the likelihood of its continuation. Commonly used technical indicators and charting patterns include trendlines, channels, moving averages, and momentum indicators.

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Technical Analysis Basics

Given that technical analysis focuses on price, movement, volume and trends, there are several basic aspects and charts that technical analysts look at rather than things like financial statements, which fundamental analysts look at.

What are some of the basics of technical analysis and how are they used to analyze stocks?

Price

One of the biggest factors technical analysts examine is the price of the security. In fact, price action is the primary measure considered when conducting technical analysis.

Technical analysts start by examining charts that show a security's price and trading volume to note its historical performance and help predict future movements.  The basic function of using charts to examine stocks or other securities is to identify trends in the investment's price or trading volume and how those trends change over time.

Technical analysis views investor attitudes and behavior (i.e., the market's psychological aspects) as the biggest movers of securities prices over time. And given the often-cyclical nature of trading patterns, they're also key indicators of how prices will move and change in the future.

Chart Patterns and Analysis

As the bread and butter of technical analysis, chart patterns are one of the main ways analysts examine and predict where a stock or security will trade down the road.

One of the most important parts of charts for technical analysis is a so-called "trend line," which shows a security's overall price trend. Additionally, things like "peak/trough analysis" and "moving averages" can help investors or analysts get a better prediction of what stocks are going to do.

While charts look very mathematical, they're really based on plotting and giving a visual representation to investor emotion and market psychology, depicting moves in prices over time.

There are several types of charts that technical analysts examine, including candlestick charts, line charts, bar charts and more:

Volume

Another major factor used in technical analysis is volume. Volume is simply the number of shares or contracts that trade for a certain security over a certain period of time, which is generally one day.

For technical analysis, looking at the volume of a stock or security can help analysts determine the strength of a price movement or trend by showing the amount of shares being traded in that direction (up or down). Volume is expressed as a bar chart at the bottom of a financial chart below the price line (the red and green bars in the charts above). The higher the bar, the higher the trading volume.

In addition to helping confirm or show the strength of trends and price movements, volume can help confirm chart patterns like so-called "triangle" or "head-and-shoulders" patterns (two types of technical patterns that measure a security's trading or price trends).

Trend

For a technical analyst, trend is perhaps one of the most important indicators of a stock or security's future performance. Technical analysis prizes examining historical trends to forecast what a stock's price might do in the future. For this reason, human behavior and emotions play a surprisingly key role in technical analysis, as patterns of trading and price movements from the past often indicate how the stock or security might behave in the future.

There are many different trends, some with strange names like "triangles" and "head and shoulders." (Some other patterns include "rectangles," "cup and handle," "flags and pennants," "candlesticks" and more.)

The three main types of trends are "uptrends," "downtrends" and "horizontal" trends. Uptrends are characterized by higher lows and higher highs, while downtrends are characterized by lower lows and lower highs. (Horizontal trends involve highs and lows that are essentially unchanged.)

And while you could get into the weeds examining each different trend, in general, trends represent the overall direction of a stock's price, which might include its highs and lows.

In addition, trends have various lengths that analysts use to interpret data -- most commonly "short term," "intermediate term" and "long term." Stocks can experience different trends in the short term (like a brief decrease in price) while still experiencing growth in the long term, so it's important to understand the time frame when analyzing trends.

Momentum

Momentum measures the speed of the price changes or movements of a particular stock or security. Often coupled with the so-called "relative strength index" (RSI), momentum tracks and measures the rate of price increases or decreases over a set period of time. For example, you could examine the momentum of the price changes for a stock like Disney (DIS) - Get Walt Disney Company Report for a 10-day period to see the rate of the rise and fall.

The RSI assigns stocks a value of between 0 and 100 and tracks whether the market is overbought or oversold for a stock. It's generally examined on a daily basis.

Support and Resistance

When looking at charts and price movements of a stock or security, technical analysts will also examine the stock's "support" and "resistance" levels. Those are the security's previous lows (support) and highs (resistance) that are above or below the stock's current price. These can help indicate if a stock is on a bullish or bearish trend.

Support represents a price where demand for a stock is high enough to typically prevent the price from dipping below that line. Conversely, resistance represents the point where sellers of the stock will come in a dump their shares, keeping the security from moving above a higher price.

If a stock's price dips below its recent support line, that's bad news that could indicate a bearish trend for the security. But if a stock breaks above its recent resistance line, that typically means that the name is experiencing a bullish trend. In essence, support is the floor price of the stock supporting it to stay higher, while resistance is the ceiling that's keeping the stock's price from going higher:

Once a stock breaks through its resistance line, that line becomes the security's new support line. Examining where a stock's price currently sits between the support and resistance lines is a major tool that technical analysts use to determine price trends. Because stock prices tend to bounce between support and resistance lines, both are crucial to predicting when a price might move or not (and in which direction).

Support and resistance levels are extremely important in identifying trends and when they might reverse. That's why they're one of technical analysis' key concepts.

Moving Averages

When looking at a daily stock chart, the jagged lines going up and down can sometimes look messy or confusing. That's why examining so-called "moving averages" -- the average of a stock's past price movements -- can help show trends more clearly. These focus on a security's average price movements instead of its day-to-day changes.

There are two types of moving averages -- "simple moving averages" (SMAs) and "exponential moving averages" (EMAs). A simple moving average takes the sum of all the closing prices of a given time period and divides them by the number of prices used. For example, you calculate a 30-day SMA by adding up a stock's closing price over the past 30 market days and dividing that 30.

EMAs use a far more complex formula that weighs more-recent prices slightly more than older ones.

Once a stock breaks through its resistance line, that line becomes the security's new support line. Examining where a stock's price currently sits between the support and resistance lines is a major tool that technical analysts use to determine price trends. Because stock prices tend to bounce between support and resistance lines, both are crucial to predicting when a price might move or not (and in which direction).

Support and resistance levels are extremely important in identifying trends and when they might reverse. That's why they're one of technical analysis' key concepts.

Indicators and Oscillators

Apart from just resistance or support levels, technical analysts also examine some key indicators like "money flow," "volatility," "momentum" and more to get a mathematical view of the stock or other security.

Indicators are calculations based on statistics like price and volume that help confirm chart patterns and other trends. They're designed to create buy or sell "signals" that help traders or analysts determine where to best enter or exit a trade (and therefore make the most money). By examining these indicators, analysts are able to better confirm a stock's price movements, and therefore the validity of specific chart patterns that experts think they're seeing.

There are plenty of indicators that technical analysts use. Some of the main ones include the "Moving Average Convergence/Divergence" (or "MACD"), the "Aroon indicator" or "Fibonacci retracements."

Indicators can be "lagging" or "leading," meaning that they're either using past data to help describe what's happening to a stock's price or that they're predicting future price action.

Some of these indicators are also "oscillators," or tools that functions by showing short- term overbought or oversold conditions of stocks. Oscillators are typically bound in a certain range (or between set levels or lines).