Technical analysis for trading

If you’re just starting out as an investor or beginning to learn how to trade stocks and shares, you need a plan and a strategy. Understanding the basics of technical analysis is a great way to sharpen your investing skills, giving you a solid trading foundation to build from.

What is technical analysis?

This is one of the main methods used by traders to research potential price movements of assets. The basic concept involves interpreting price and volume charts to spot patterns or movements based on historical data and trading psychology.

It’s mostly used for researching stock trades. But, the techniques can apply to most assets that have enough historical data available. This includes securities such as commodities, currencies (forex), futures, fixed-income assets (bonds) and cryptocurrencies.

Wait, what?: The theory behind technical analysis

We can hear you thinking it: “Wait, what? How about all that ‘Past performance is not indicative of future results’ stuff? How about company performance, market trends and all that? Aren’t they supposed to be important factors to decide whether it’s time to buy or sell?”

Well, the validity of technical analysis is based on two theories:

1. 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.
2. Price movements aren’t random, they follow trends. So historic data, if properly analysed, 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 or not, is up for debate.

How is technical analysis used in trading?

By looking at statistics and trends in prices and trading volumes, traders use this data to make educated guesses on where the price of an asset could be heading next. The information often relates to relatively short-term movements rather than major long-term trends.

This allows traders to use technical analysis to gauge potential possibilities and outcomes for the price of shares and other assets. However, skilled traders and professional investors will often use other forms of research in addition to technical analysis before making investment decisions.

How accurate is technical analysis?

It’s not an exact science. There are no foolproof formulas or tactics because there are so many variables at play with any single investment. That said, skilled traders can often be fairly accurate with a stated margin of error.

Yet, unexpected things can happen in the markets. Unpredictable factors can influence assets. These events are often not accounted for with technical analysis, meaning that the eventual results can fall way outside the estimated price ranges determined by traders.

What are the different types of technical analysis?

This analysis relies on a broad range of patterns and signals. The methods have developed and evolved since the introduction of the first theories by Charles Dow at the end of the 19th century.

The following are the two main types of technical analysis:

1. Top-down. This is a popular choice for short-term traders. It starts by looking at the overall economy. And then, gradually works through a sector or industry before finishing with the evaluation of a stock.
2. Bottom-up. With this approach, traders begin by looking at an individual stock or asset, attempting to find useful entry and exit points that could play out over a long-term trade.

Here are some of the major indicators and signals used to support the various theories and methods of trading based on technical analysis:

• Price history
• Volume and momentum data
• Reoccurring chart patterns
• Moving averages
• Oscillators
• Resistance and support levels

How to use technical analysis when trading

Here’s a step-by-step overview explaining how you can use technical analysis for trades:

1. Open an account. Make sure you have an investment account that allows you to trade with low fees.
2. Create a plan. Decide which trading method and strategy you want to use.
3. Research. Carry out your initial research and then decide your trading parameters, including possible entry and exit points.
4. Set up your trades. Use different order types to make your trading more efficient and automated.
5. Execute trades. Use your research and knowledge to follow through on your desired trades within a set time frame.

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How important is this type of stock analysis?

These trading methods and systems have heavily influenced many traders throughout the last hundred years or so. For dedicated traders, technical analysis forms the basic principles used to dictate their theories for the price movement of assets.

Technical analysis is just one tool to keep in your toolbox. It’s not a cheat code that allows you to predict exactly what’s going to happen with stocks. This is why the best traders will layer other forms of research on top of their technical analysis – it helps provide as clear a picture as possible before trading.

Technical analysis vs fundamental analysis

This is a debate that rages on among investors. What’s best – technical analysis or fundamental analysis? The truth is, neither is definitively superior. Both can play an important role when you’re researching possible trades for stock or other assets.

In general, technical analysis can be more useful for figuring out shorter-term price movements. But, if you rely solely on technical analysis, you could miss an obvious warning signal. You could also miss a positive sign that you would have been aware of with just a small bit of fundamental analysis.

What are the limitations of technical analysis?

This type of investment research can have a narrow focus because it’s the small details that make a difference. It’s this attention to detail that makes technical analysis useful, but this strength can sometimes be its biggest weakness.

Here are some of the major drawbacks and limitations of using technical analysis for investing and trading:

• History never repeats exactly.
• It can be an information overload for new investors.
• Sometimes trading methods lead to a self-fulfilling prophecy.
• Research findings can sometimes be vague or give mixed signals, telling traders the price could go up or down.
• It’s very rare that a high level of accuracy can be determined for asset price movements.
• Some charts and patterns can be interpreted differently, and these differences in opinions can lead to opposing conclusions.
• It doesn’t provide any context for the investment. For example, it gives no information about an industry or competition for a stock.
• Used on its own, it doesn’t give you a complete picture.
• Without an understanding of trading orders, you often need to keep an eye on trades in real time, which can be time-consuming.

Benefits of learning technical analysis

Although it has its drawbacks, there are some very useful benefits for traders willing to put in the time and learn how to use technical analysis to their advantage:

• The detailed information gives you a quick insight into the current state of an asset just by looking at a single chart.
• Only using price and volume data can make it more objective and less subject to bias surrounding the asset or stock.
• It’s one of the only investment research methods that account for human emotion and psychology.
• Once you understand some basic chart patterns, it can be easy to apply these theories to a wide range of investments without in-depth industry knowledge of each asset.
• Nowadays, it’s cheap and easy to access tools and charts that allow you to perform your own technical analysis without expensive resources.
• Most technical analysis can be used across a range of assets and investments, making it efficient for you to understand a diverse variety of securities.

How to use it to your advantage

The best way to get the most out of technical analysis is to make sure you don’t use these skills in isolation. If you’re able to combine this with other types of analysis, you’ll be able to build a clearer understanding of possible price movements.

Armed with information from different types of research, you’ll be able to make better decisions as a trader or as an investor. This will reduce the likelihood that you’ll make costly mistakes, and it can improve your chances of trading profitably.

Our expert says: What’s the biggest mistake beginners make when using technical analysis?

"Overcomplicating things! It’s easy for new traders to get caught up loading 10 different technical indicators onto a single chart until it looks like a confusing game of Tetris.

When you stack too many overlapping indicators, you end up with “paralysis by analysis”, where conflicting signals leave you completely unable to make a clear trading decision.

The most effective traders usually keep it simple by mastering two or three complementary tools."

George Sweeney, DipFA

Deputy editor

Bottom line

Learning how to use technical analysis properly will greatly improve your ability as a trader. And, it can help you make more profitable decisions. However, this type of analysis isn’t a silver bullet and it doesn’t provide a guaranteed way to make money when trading stocks or other assets.

Technical analysis can be extremely useful to both traders and investors. If you really want to boost your investing skills, it’s best used in partnership with other methods of investment research.

Frequently asked questions

• What are the methods of technical analysis?

  The 2 major methods involve a top-down or bottom-up approach, but there can be plenty of unique ways to invest using technical analysis.

• What are technical analysis skills?

  These are skills you can develop to gain a better understanding of charts and patterns relating to price and volume data for stocks and other assets.

• How do I start studying technical analysis?

  There are plenty of free resources you can access on the internet, including videos, courses and articles. A few investment platforms geared towards traders will also have information. And, sometimes demo accounts that allow you to practice your skills. If you prefer an old-school approach, there are also loads of books covering this topic.

• How do you predict a trading chart?

  There’s no way to predict exactly what’s going to happen. You can use technical analysis strategies to make an estimation of where you think the price of an asset will go next. That could simply be an increase or decrease in price. But ideally, you will also come up with a potential range for the change.

• 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/selling.

  If you want to give it a go, keep in mind that there are no guarantees. Don’t expect 100% accurate predictions, nor to make easy money super quickly. Instead, treat it like a set of relevant information you need to filter and understand in order to use it in the best way.

• 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 on the idea that price movements follow regular patterns that tend to repeat themselves: they believe they’re often random instead.

Written by

George Sweeney, DipFA

Deputy editor

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George is a deputy editor at Finder. He has previously written for The Motley Fool UK, Nasdaq, Freetrade, Investing in the Web, MoneyMagpie, Online Mortgage Advisor, Wealth, and Compare Forex Brokers. He's focused on making personal finance and investing engaging for everyone. To do this he draws from previous work and his Level 4 Diploma for Financial Advisers (DipFA), sharing what he’s learnt. When he’s not geeking out about money, you’ll find him playing sports and staying active. See full bio

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