Technical analysis is a trading method used to analyze investments and identify trading opportunities by studying statistical trends like price movement and volume.
What Is Technical Analysis Exactly?
Technical analysis was a methodology created by Charles Dow, co-founder of the Wall Street Journal and the Dow Jones Industrial Average, who used price and volume data to predict security prices. These three main principles of technical analysis are based on the six tenets developed by Charles Dow in his Dow Theory.
Price refers to the cost of a single share, while volume refers to the number of shares of a security traded in a given time frame. Different types of price charts are used in technical analysis, which then determines price and volume and signals whether to buy or sell.
How Is Technical Analysis Used?
Technical analysis is a method used to forecast price movements of tradable instruments like stocks, bonds, futures, and currency pairs. There are many patterns and signals that affect the prices of shares and stocks and experts have developed set patterns that support technical analysis trading.
Technical analysis helps people decide when to open a buy or sell deal based on changing supply and demand, which can also affect the price of a security. Technical analysis also studies past price movements to determine the future of a particular security or group of securities.
Certain principles that underpin technical analysis can help improve your investment research and develop better technical analysis results. Let’s discuss.
How Technical Analysis Works
There are three basic principles at the heart of technical analysis. These are:
- Market action is the main determinant for everything
- Market movement is dictated by trends
- Market moves in waves and historical information is important
Market action is the main determinant for everything
The first and most important principle of technical analysis is that a stock’s value is reflected in the stock price. The effect of this stock value is seen in its price and the response by the market. News, facts and data are all utilized for one singular purpose, which is, to decide whether to open a buy deal or a sell deal. This one single decision is responsible for changes in both price and volume. The price is the most important determinant and what technical analysis focuses on most. The price tells us whether the market is in profit or in a loss. As market prices fluctuate, the net asset value also changes. All this is to say, market action determines everything and is the most important fact and principle behind technical analysis.
Market movement is dictated by trends
The second basic principle of technical analysis is that prices are determined by trends, which will continue to move in the same direction unless some indicator suggests a reversal. There are many different technical indicators and the investor may choose any one of them. The basic idea is that the trend needs to be followed for an accurate analysis. As an example, say the price has been rising consistently, but a technical indicator shows that it will start to fall. In this case, an investor would follow trends and may choose to open a sell deal for that particular instrument.
A market that is rising points to a trend that will likely continue to rise or, if the market is falling, will continue to fall. On the other hand, if the market is stagnant, it will remain that way. This is also the main reason why the trend is given so much importance in technical analysis, and following the trend is important for an accurate analysis of the market.
The market moves in waves and historical information is important
The last important principle of technical analysis is that historical patterns and trends are extremely important to determine current stock price movements. Technical analysis believes that patterns that have happened historically tend to repeat themselves. The market moves in waves and, as information keeps changing, the market has a moving target. Furthermore, a technical analysis must rely on market psychology to interpret patterns in price charts. While the market has an unknown target price that is determined by fundamentals, changing information changes the market moving target. The target does not always move in a straight line to the target price.
Market psychology refers to the collective sentiment of investors in the market, and keeping an eye on this psychology is important to accurately determine ups and downs in instrument prices. Technical analysis places importance on keeping an eye out for investor sentiment and behaviour. For example, if investors are optimistic about a security, they may open a buy deal. This will result in the price being pushed up. On the other hand, if investors are pessimistic, they will open a sell deal and prices will fall.
Traders are operating in different time frames and have different needs. The result of this is that demand could exceed supply at one moment and supply could overcome demand in the next moment. The imbalance results in changes in prices and the price changing in waves. Technical analysis places special emphasis on these changing waves to determine the most probable max/min prices of a security and for increasing the accuracy of analysis during trading.
Always keep in mind that while technical analysis can be extremely helpful, it is only meant to provide insight and never to be taken as a guarantee.