What Is Technical Analysis?

Technical analysis is a method of forecasting the direction of securities by studying past market data. The process is based on the assumption that the collected market data, such as charts of price, volume, and open interest, can help predict the future of short-term market trends.

Technical analysis differs from fundamental analysis in that the intrinsic value of the security is not considered. The field of analysis is based on the following assumptions:

• The market discounts everything.
• Price moves in trends.
• History tends to repeat itself.

The Market Discounts Everything
A major criticism of technical analysis is that it only considers price movement, ignoring the fundamental factors of the company. However, technical analysis assumes that, at any given time, a stock's price reflects everything that has or could affect the company - including fundamental factors. Technical analysts believe that the company's fundamentals, along with broader economic factors and market psychology, are all reflected in the price of the stock, removing the need to actually consider these factors separately. This only leaves the analysis of price movement, which technical theory views as a product of the supply and demand for a particular stock in the market.

Price Moves in Trends
In technical analysis, price movements are believed to follow trends. This means that after a trend has been established, the future price movement is more likely to be in the same direction as the trend than to be against it. For example, if a stock is on a downward trend, each time it moves lower, it usually falls below its previous low price, resulting in “lower lows.” Similarly, a stock can be in a downward trend even with improved sales if it finishes with “lower highs,” which means that the stock could not reach the level of its previous high. Most technical trading strategies are based on this assumption.

History Tends To Repeat Itself
Another important idea in technical analysis is that history tends to repeat itself, mainly in terms of price movement. The repetitive nature of price movements is attributed to market psychology; in other words, market participants tend to provide a consistent emotional reaction to similar market stimuli over time. Through technical analysis, chartists use chart patterns to analyze market movements and understand trends which enables them to predict how market participants will react to a security. Although many of these charts 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.

What Tools Are Used to Learn Technical Analysis?

There are many different types of technical traders with just as many investment styles on the fundamental side. Some rely on chart patterns; others use technical indicators and oscillators, and most use some combination of the two. In any case, technical analysts' exclusive use of historical price and volume data is what separates them from their fundamental counterparts. Unlike fundamental analysts, technical analysts don't care whether a stock is undervalued - the only thing that matters is a security's past trading data and what information this data can provide about where the security might move in the future.

By analyzing the statistics generated by market activity, such as past prices and volume, technical analysts evaluate securities. They do not attempt to measure a security's intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity. Technical analysts believe that they can accurately predict the future price of a stock by looking at its historical prices and previous trading variables. Additionally, technical analysis assumes that market psychology does have an influence on trading in a way that makes it possible to predict when a stock will rise or fall. For that reason, many technical analysts are also market timers, who believe that technical analysis can be applied just as easily to the market as a whole as to an individual stock. Technical analysis is not just for stocks. It can be used on any security with historical trading data.

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Next: Technical Analysis: Trends