What is Technical Analysis?
Stated plainly, Technical Analysis is a popular mode of trading the stock market, forex market, etc with the use of charts instead of analyzing the fundamental data of a stock, currency,etc, such as how much money has this security made in the last year? Is it an improvement from 5 years ago? Are they innovative? You get the point. Using technical analysis you ignore or at least mostly ignore information outside of the chart. Technical Analysts instead observe the price on a chart and how the players of the market are reacting to it. Are people buying now? Do people want to sell? That’s technical analysis at its core.
Chart Analysis
Chart Analysis, or in other words what technical analysts look analyze in charts. Now you know that technical analysis is a study of the financial markets through charts, but what are they looking for? Much like a meteorologist who may predict the probability of rain through weather patterns so does a chart analyst with price or volume patterns. A chartist may see that a certain pattern such as a break through an important price such as 100 which has a psychological impact to conclude that there is a good chance that the stock price will dip to 90.
This trader has a more obviously complex system in place and would be useful for a more experienced trader. For now since you are a just beginning to learn the basics of technical analysis I would strongly recommend you begin by reading our basics of trading after reading this page. To summarize, chart analysis involves looking at patterns, price ranges that show support, trends, volume (how many are buying and selling), etc, to determine the direction of a stock.
Fundamentals of Technical Analysis
Starting in the beginnings of the 20th century, the foundations of technical analysis were being laid by financial geniuses. Geniuses such as Charles Dow who created the Dow Theory. Much like Newton to Science, Dow is to the financial markets.
Dow proposed many natural laws that control and display the behavior of the market, three of the most notable:
Price Discounts Everything
Price Movements are Not Random
“What” Price is, is More Important than “Why” Price is
Price Discounts Everything
Contrary to the belief of most financial all stars at the time. Dow believed that “Price Discounts Everything”, (also called the Efficient Market Hypothesis and better explained ) meaning that price is reflected by all of the information and therefore it is the correct value of the security(stock, currency, commodity, etc), and that therefore all you really need to do is analyze the price because it is the consummation of all the information available. Technical analysis therefore analyzes the all knowing price and interprets the direction of the market.
Price Movements are Not Random
At the onset of the 1900s, most of Charles Dow’s contemporaries believed in the Random Walk theory, that price is random. The basis of the Dow’s theorem that price movements are not random is that prices trend and are only interspersed with small periods of random fluctuation (consolidation periods, ranges). The goal of the technical analyst should be therefore to identify the trend and to ride it.
fundamentals of technical analysis
“What” Price is, is More Important than “Why” Price is
The difference between a fundamental analyst (looks at a company’s money flow, news, etc,) and a technical analyst is that the fundamental analyst is concerned with why price is. Were earnings less than expected, did the CEO get charged with tax evasion, is their new product selling? These are all questions a fundamentalist would be asking and trying to answer what this would have in store for the price in the future.
The Technician only cares about what the price is, not why. Supply and demand, the price went up because there’s more buying than selling why should I care why there is more buying?
Pros and Cons of Technical Analysis
Technical analysis vs. Fundamental analysis, there will always be debates over which is a better school of trading. Neither is perfect and neither is truly worse. You can be a master at both and make a profit, or be a failure at both. There are pros to technical analysis and there are faults as well. Lets start with the good.
PROS
Analyzing Price
If you wish to know the future of price, then you should ask price. This is a strength for technical analysis because price movements usually precede fundamental developments, except for a catalyst such as earnings report but even then as a technical analyst you wouldn’t need to take a peek at the earnings report because what matters to you is the market’s reaction to the earnings report only.
Supply and Demand witnessed in Price
Supply and demand shows itself in the most basic form in the price action of a chart. You can directly see the buying pressure and the selling pressure among prices. You can see where demand to take a price is low and where it is high, etc.
Price Action
Simple Analysis
Regardless of the setups you may see of traders having lines all over their charts that you don’t understand as of yet, trading is actually very simple. Before even moving onto the first step in trading, “Support and Resistance” you have already witnessed it right in front of you. The previous chart showed that there was resistance at 1.500 and support at 1.4700, therefore if price were to break through either point than buying pressure is higher than selling pressure, to learn more check here.
Making an Entry or an Exit from a position
Even if you are a fundamentalist, you still need basic technical analysis skills. Even if a company you think has great financial backing, etc, the price of the company or stock may be extremely high and may be on the onset of a pullback (dip in price). If you had basic technical analysis skills you could be patient for the pullback and buy low and wait for it to get higher.
CONS
Trader Bias
A trader’s bias can fondle true judgement of a security and its true direction. Bias can creep upon a technician from everywhere. A trader may have found it hard to believe that a bullish stock such as AAPL could have dropped from 700 to 390 in less than half a year. They would have laughed at their face while buying up more stock.
Room for Vague Interpretation
The thing about technical analysis is that although patterns themselves may be defined objectively they also leave room for subjective thinking. And in most critical cases this is what makes the difference between entering a winning trade or losing one. The good thing about this con is that after practice you can accurately judge more clearly and this con isn’t as much as a problem. And hey if it was as easy as finding a pattern then everyone would be trading.
Signals are Too Late
Technical Analysis is often criticized for the fact that signals (signals to buy or sell) come too late. They argue that by the time you identify the signal and test it, the move has already been made and no more profit can be made. This does happen sometimes, but usually once you find yourselves a trading system that works this shouldn’t be a problem.
Emotion
Your emotions are the main obstacle you must accomplish before you can be consistently profitable. The thing is that most of us humans aren’t made to go through these emotional swings and still have the patience to hold out. You enter a trade and immediately begin losing money, by the time the worst is over you are out of the trade because you were stressed out that your savings were going to be decimated in one swing. As soon as you sell the stock skyrockets and would have made you $$$. You feel like kicking yourself and you probably do.
This is why traders say that trading is 80% psychological and 20% trading.
Conclusion
Technical analysis in short, is the analyzing of financial markets through price action through charts. Chart analysts analyze a chart for patterns, supply and demand, etc. That’s the easy part, next is what separates the winners from the pigs. Vague interpretations, late signals and controlling your emotion, now that’s what makes this a difficult profession. Technical analysis can be your angel of freedom and $$ or your angel of death, the choice is up to you.