If you’re trying to put your investing strategy together, you’ll have seen a few technical analysis charts around. You probably wonder what this whole thing means, why it gives different results with different time frames and — especially — what on earth it’s based on.
This guide will walk you through the basics of technical analysis. Our aim is that when you finish reading, you grasp the gist of it without the urge to bang your head against the wall.
What is technical analysis?
Technical analysis tries to predict when it’s a good time to buy or sell a commodity. These commodities can be stocks, currencies, gold – anything for which there is historical price data.
Technical analysis uses statistics to analyze past price movements and volume and other trading indicators. Then, it says whether the indicators suggest it’s a good time to buy.
To a degree, it’s a bit like the robot version of an investment advisor, but its predictions and advice are entirely based on past data and statistics.
The theory behind technical analysis
The validity of technical analysis is based on two theories:
- Prices already include all market factors. According to technical analysis theory, you don’t really need to look at how a company is doing or at the rest of the market because the price of a commodity already takes all these things into account. All available information is reflected there, so there’s no point in doing more research or looking at anything else.
- Price movements aren’t random — they follow trends. So, historical data, if properly analyzed, can give information on future performance.
This means that if, for example, something suddenly goes wrong with a company, technical analysis is not necessarily going to reflect it. Technical analysis only works if condition one is satisfied — that is, if market prices reflect all available information. Whether that’s always true is up for debate.
Technical analysis vs. fundamental analysis
Not all experts believe in technical analysis, and many complement it with its opposite: fundamental analysis.
Fundamental analysis looks at all those “external” factors that technical analysis neglects because it considers them included in the price of a commodity — for example, a company’s performance, its competitors, general market trends, socio-political context and so on.
How technical analysis works
Technical analysis involves analyzing historical price data and trading volumes to forecast future price movements of securities. Traders use this method to identify trends, support and resistance levels, chart patterns and indicators or oscillators. By examining price charts, analysts identify trends such as uptrends, downtrends and sideways movements, which may help predict future price directions.
Support and resistance levels are points where significant buying or selling pressure occurs, aiding in determining optimal entry and exit points for trades. Chart patterns, like triangles or head and shoulders, provide additional insights into potential trend reversals or continuations. Indicators and oscillators, such as moving averages or Relative Strength Index (RSI), offer further tools to analyze price momentum and identify buy or sell signals.
Does technical analysis work?
This is the million-dollar question, isn’t it? The somewhat less-than-satisfying answer is that it can work. Technical analysis is a tool, not a guarantee.
You can use it to your advantage, but you need to learn how. For example, different indicators can be more suitable for your investing strategy or for the commodity you’re buying or selling.
If you want to give it a go, keep in mind that there are no guarantees. Don’t expect 100% accurate predictions or to make easy money quickly. Instead, treat it like a set of relevant information you need to filter and understand to use it best.
Frequently asked questions
Is technical analysis only for short-term trading?
Not necessarily. Many traders use it for long-term investment strategies as well.
What are the main arguments against technical analysis?
There are a few. As we’ve mentioned, not everyone is persuaded that all relevant market information is already included in a stock’s price (the so-called “efficient market hypothesis” — which, as the name suggests, is indeed a hypothesis, not an established truth). Fundamental analysts also tend to disagree that price movements follow regular patterns that tend to repeat themselves. They believe they’re often random instead.
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