Technical Analysis

What Is Technical Analysis?

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.

KEY TAKEAWAYS

 Technical analysis is a trading discipline employed to evaluate investments

and identify trading opportunities in price trends and patterns seen on
charts.
 Technical analysts believe past trading activity and price changes of a
security can be valuable indicators of the security's future price
movements.
 Technical analysis may be contrasted with fundamental analysis, which
focuses on a company's financials rather than historical price patterns or
stock trends.
Understanding Technical Analysis
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 can be used on any security with historical trading data. This
includes stocks, futures, commodities, fixed-income, currencies, and other
securities. In this tutorial, we’ll usually analyze stocks in our examples, but keep
in mind that these concepts can be applied to any type of security. In fact,
technical analysis is far more prevalent in commodities and forex markets
where traders focus on short-term price movements.

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. Nowadays
technical analysis has evolved to include hundreds of patterns and signals
developed through years of research.

Technical analysis operates from the assumption that past trading activity and
price changes of a security can be valuable indicators of the security's future
price movements when paired with appropriate investing or trading rules.
Professional analysts often use technical analysis in conjunction with other forms
of research. Retail traders may make decisions based solely on the price charts
of a security and similar statistics, but practicing equity analysts rarely limit their
research to fundamental or technical analysis alone.

Among professional analysts, the CMT Association supports the largest

collection of chartered or certified analysts using technical analysis professionally
around the world. The association's Chartered Market Technician (CMT)
designation can be obtained after three levels of exams that cover both a broad
and deep look at technical analysis tools. The association now waives Level 1 of
the CMT exam for those who are Certified Financial Analyst (CFA)
charterholders. This demonstrates how well the two disciplines reinforce each
other.2

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. In fact, some view technical
analysis as simply the study of supply and demand forces as reflected in the
market price movements of a security. Technical analysis most commonly
applies to price changes, but some analysts track numbers other than just price,
such as trading volume or open interest figures.

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.

In general, technical analysts look at the following broad types of indicators:

 Price trends
 Chart patterns
 Volume and momentum indicators
 Oscillators
  Moving averages
 Support and resistance levels

Underlying Assumptions of Technical Analysis

There are two primary methods used to analyze securities and make investment
decisions: fundamental analysis and technical analysis. Fundamental analysis
involves analyzing a company’s financial statements to determine the fair value
of the business, while technical analysis assumes that a security's price already
reflects all publicly available information and instead focuses on the statistical
analysis of price movements. Technical analysis attempts to understand the
market sentiment behind price trends by looking for patterns and trends rather
than analyzing a security's fundamental attributes.

Charles Dow released a series of editorials discussing technical analysis theory.

His writings included two basic assumptions that have continued to form the
framework for technical analysis trading.

1. Markets are efficient with values representing factors that influence a

security's price, but
2. Even random market price movements appear to move in identifiable
patterns and trends that tend to repeat over time.3

Today the field of technical analysis builds on Dow's work. Professional analysts
typically accept three general assumptions for the discipline:

1. The market discounts everything: Technical analysts believe that

everything from a company's fundamentals to broad market factors
to market psychology is already priced into the stock. This point of view is
congruent with the Efficient Markets Hypothesis (EMH) which assumes a
similar conclusion about prices. The only thing remaining is the analysis of
price movements, which technical analysts view as the product of supply
and demand for a particular stock in the market.
2. Price moves in trends: Technical analysts expect that prices, even in
random market movements, will exhibit trends regardless of the time frame
being observed. In other words, a stock price is more likely to continue a
past trend than move erratically. Most technical trading strategies are
based on this assumption.
3. History tends to repeat itself: Technical analysts believe that history tends
to repeat itself. The repetitive nature of price movements is often attributed
to market psychology, which tends to be very predictable based on
emotions like fear or excitement. Technical analysis uses chart patterns to
analyze these emotions and subsequent market movements to understand
trends. While many forms of technical analysis have been used for more
 than 100 years, they are still believed to be relevant because they illustrate
patterns in price movements that often repeat themselves.4

Technical Analysis vs. Fundamental Analysis

Fundamental analysis and technical analysis, the major schools of thought when
it comes to approaching the markets, are at opposite ends of the spectrum.
Both methods are used for researching and forecasting future trends in stock
prices, and like any investment strategy or philosophy, both have their advocates
and adversaries.

Fundamental analysis is a method of evaluating securities by attempting to

measure the intrinsic value of a stock. Fundamental analysts study everything
from the overall economy and industry conditions to the financial condition and
management of companies. Earnings, expenses, assets, and liabilities are all
important characteristics to fundamental analysts.

Technical analysis differs from fundamental analysis in that the stock's price and
volume are the only inputs. The core assumption is that all known fundamentals
are factored into price; thus, there is no need to pay close attention to them.
Technical analysts do not attempt to measure a security's intrinsic value, but
instead, use stock charts to identify patterns and trends that suggest what a
stock will do in the future.

Limitations of Technical Analysis

Some analysts and academic researchers expect that the EMH demonstrates
why they shouldn't expect any actionable information to be contained in historical
price and volume data. However, by the same reasoning, neither should
business fundamentals provide any actionable information. These points of view
are known as the weak form and semi-strong form of the EMH.

Another criticism of technical analysis is that history does not repeat itself
exactly, so price pattern study is of dubious importance and can be ignored.
Prices seem to be better modeled by assuming a random walk.

A third criticism of technical analysis is that it works in some cases but only
because it constitutes a self-fulfilling prophecy. For example, many technical
traders will place a stop-loss order below the 200-day moving average of a
certain company. If a large number of traders have done so and the stock
reaches this price, there will be a large number of sell orders, which will push the
stock down, confirming the movement traders anticipated.

Then, other traders will see the price decrease and also sell their positions,
reinforcing the strength of the trend. This short-term selling pressure can be
considered self-fulfilling, but it will have little bearing on where the asset's price
will be weeks or months from now. In sum, if enough people use the same
signals, they could cause the movement foretold by the signal, but over the long
run, this sole group of traders cannot drive price.

What Assumptions Do Technical Analysts Make?

Professional technical analysts typically accept three general assumptions for the
discipline. The first is that, similar to the efficient market hypothesis, the market
discounts everything. Second, they expect that prices, even in random market
movements, will exhibit trends regardless of the time frame being observed.
Finally, they believe that history tends to repeat itself. The repetitive nature of
price movements is often attributed to market psychology, which tends to be very
predictable based on emotions like fear or excitement. 

What's the Difference Between Fundamental and Technical Analysis?

Fundamental analysis and technical analysis, the major schools of thought when
it comes to approaching the markets, are at opposite ends of the spectrum.
Fundamental analysis is a method of evaluating securities by attempting to
measure the intrinsic value of a stock.

The core assumption of technical analysis, on the other hand, is that all known
fundamentals are factored into price; thus, there is no need to pay close attention
to them. Technical analysts do not attempt to measure a security's intrinsic value,
but instead, use stock charts to identify patterns and trends that might suggest
what the security will do in the future.

How Is Technical Analysis Used?

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.