A Beginner's Guide to Technical Analysis in Trading and Investing

Long-term, buy-and-hold investors value equities based on the underlying company’s fundamentals, such as their profitability, free cash flow, or sales figures. They believe the market price will reflect these factors in the long run. However, as technical traders like to point out, there can be significant price deviations in the short term based on changes in supply and demand.

Technical analysis is a powerful tool to determine trading opportunities based on chart patterns. Instead of evaluating the health of the available assets in terms of their basic economic properties, technical analysis uses price and volume data to determine future price trends. 

A Definition Of Technical Analysis

So what is technical analysis? It’s a set of tools that market participants, such as traders, use to forecast the future price movements of a security based on price and volume data. 

The Assumptions of Technical Analysis

As with most trading and investing strategies, technical analysis leans on various assumptions. 

Perfect Information

Technical analysis believes that stock prices already reflect all available information and that no particular market participant is better informed than any other. Therefore, it focuses more on statistical price movements and often ignores fundamental analysis entirely. 

Prior Price Movements Impact Future Performance

Technical analysis theory also assumes that prior price movements offer information that permits predictions of future performance. For instance, if a company has “momentum” today, the upswing in price is more likely to continue. 

Prices Move in Trends and Countertrends

Lastly, technical analysis believes that market movements develop with identifiable patterns that repeat over time. Analysts believe they can use these patterns to forecast likely price movements, opening up profit opportunities. 

The Difference Between Technical Analysis and Fundamental Analysis

Fundamental analysis involves looking at a company’s performance and then determining whether the stock price reflects “fair value” for the firm. For instance, investors such as Warren Buffett look at the real-world business performance of the company and then attempt to figure out whether the market has assigned the correct value to the stock. If the stock price is lower than the “fair value” (as determined by the investor), they should buy. If the price is higher, they should sell. For example, the price could be higher than the fair value because investors are exuberant or lower because of excessive caution.

Implicit in this idea is that the current stock price does not reflect all available information. If the price is lower than it should be, then the market misunderstands the business's profit potential, and information is incomplete.

Technical traders actively eschew fundamental analysis because they believe that the “market discounts everything” and already reflects all available information. They can’t derive profits in the same way a value investor does.

This assumption is based on an economic theory called the efficient market hypothesis (EMH), which states that the security price always reflects all available information. The moment new information becomes available, the price changes to reflect it, denying any profit-making opportunities.

So, what exactly are technical traders exploiting, if not information advantage? Technical traders believe that price fluctuations are solely attributable to changes in supply and demand. Traders use price and volume change signals to provide them with short-term predictions on the likely direction of the price. 

Shortfalls Of Technical Analysis Trading

There's no doubt that technical analysis can be a very effective tool for trading. However, there are also some significant shortcomings to this approach that traders need to be aware of. There are three main criticisms of technical analysis: 

Technical analysis still exploits imperfect information.

If market prices adjusted perfectly to reflect all information, they would also incorporate supply and demand information, immediately changing to eliminate profits. Technical traders imply that the market is selective regarding adjusting prices, using only data relevant to fundamental analysis but not technical profit-making. 

History doesn’t repeat itself.

Technical analysis of stocks also relies on the notion that price patterns repeat themselves. However, some critics argue that price histories can’t predict future trends. Data indicates that prices follow stochastic or random-walk processes, not repeatable patterns.

Multiple technical traders influence the market.

Lastly, critics point out that the decisions of technical traders influence the market price, undermining their independent assumptions. For instance, if multiple technical traders believe that a dip below the 100-day moving average is an opportunity to sell, they may cause the market to fall even further by acting in concert, forcing a deviation from the fair value that has nothing to do with security’s value.

The Basics of Technical Analysis Trading

Once you’ve accepted the tenets of technical analysis, the next step is to get to grips with the available tools. As you might expect, technical traders have developed tools to help them make better buying and selling decisions. 

Charts

Charts are technical traders’ primary tools. They let analysts follow the price movements of securities and identify patterns through technical chart analysis. 

Charts display various time frames depending on the type of price action that a trader is trying to exploit. For instance, some traders attempt to make profits on the scale of minutes (perhaps because a company just released new financial information), or on the scale of a whole day, perhaps because of falling investor sentiment. 

Charts show different time scales on the x-axis, such as five and 15 minutes changes, hourly or daily. Traders may use all of these or settle on a particular time scale in which they are successful. Price changes on a 5-minute chart may be significant for quick trades but may be hard to see on a full-day chart. 

For instance, suppose wheat prices are rising because of shortages in global supplies. Traders may look at a daily chart and see the price snowballing. However, on a 5-minute chart, it could be temporarily falling, providing opportunities to make money on both the ups and downs. 

Candlesticks

Candlesticks are another fundamental tool traders use to help them quickly visualize security pricing. For instance, if a stock closes the day higher than it opens, the candlestick will display green, and if it opens higher than it closes, the candlestick will display red, as the following diagram shows:

The top and bottom of the box represent either the opening or closing price. The upper wick shows the high for the day, and the lower wick shows the low. Candlestick patterns sometimes have long wicks if there is a lot of intraday volatility in the security’s price or short wicks if it’s very little. 

Plots like this are session-specific and aren’t usually broken down into smaller units. Platforms collect information on security throughout the day (such as an S&P 500 index fund) and then publish the finalized candlestick plot at the close of trading and all the other plots from previous sessions. The result is a chart that shows traders both the historical price trend and daily volatility. 

On rare occasions, the price of a security on the opening will be the same as on the closing. When this happens, the candlestick has no body.

While the convention is for trading platforms to use red for session losses and green for session gains, not all platforms follow this format. It may be a customizable feature on an online brokerage platform of your choice. 

Moving Averages

Learning how to do technical analysis also requires an in-depth understanding of moving averages. Traders use these to evaluate the long-term price performance of a stock relative to its historical trend, informing their buying and selling decisions. 

For instance, a trader might put a stop-loss on a security if it falls below its 200-day moving average, seeing it as a bearish signal. Likewise, another trader who wants to take a position in a company stock might decide to do so the moment it falls below its 50-day moving average. 

Crossovers are another important concept when it comes to moving averages. Traders, for instance, might decide to sell when the 100-day moving average falls below the 200-day moving average, indicating that the stock’s recent performance is worse than its long-run performance. 

The longer the moving average period, the more significant crossing it becomes. Crossing the moving average for the week doesn’t say much about the underlying security. However, crossing below or above the 200-day moving average suggests that the asset is in either bearish or bullish territory. 

Technical analysis indicators include moving averages, relative strength index, and moving average convergence divergence (MACD). 

Trends

Stock charts technical analysis also involves analyzing trends. If the market is bullish or rising, traders expect to see higher highs and lows, with a generally positive price trajectory. Drawing a regression line to include all the price points would reveal an upward slope. Similarly, a bearish trend has lower highs and lower lows, overall downward-sloping. 

Traders believe that trends are more likely to persist than not. Therefore, trading a trend makes sense. If you expect the price to rise, the best strategy is to buy now and sell before the reversal. Likewise, if you can see it falling, shorting the stock and then repurchasing it from the market at a lower price could also net you a profit. 

Support and Resistance

Traders believe that some prices are more important than others. For instance, you may hear them saying things like “ARKK exchange-traded fund encountered support at its 200-day moving average,” or “Citi saw resistance breaking through the $50 barrier.” The theory here is that some prices are more difficult to challenge than others, primarily because of limited orders and take-profit orders. 

For example, if multiple investors have take-profit orders at the $50 level for CitiGroup, they will create “resistance” to pushing through that price by selling shares. Similarly, traders with limited orders will buy securities when they fall to a predefined price, reducing supply and preventing the price from falling further, creating support.

Because many traders think similarly, resistance and support can be quite predictable. For instance, if traders are bullish about a particular exchange-traded fund, support might kick in at the 100-day and 200-day moving averages, preventing the price from falling further. Likewise, if they are bearish, putting take-profit orders in place, you might expect resistance at these moving average levels. 

How To Succeed in Technical Analysis

As with all investing endeavors, succeeding in technical analysis requires the right approach. Here are some of the ways to help boost your chances of success:

Develop a Trading System

A trading system is a set of rules you’ll follow to generate a profit. When doing this for the first time, it’s good to follow tried-and-tested strategies that worked in the past. Once you better understand the various forms of technical analysis, you can expand your approach. 

Find a Quality Brokerage

If you’re planning on trading as an amateur, you’ll also need to find a brokerage that supports beginners. Remember, many platforms gear their services towards buy-and-hold investors. 

You may also want to download additional software to maximize your performance. Mobile alerts, for instance, can be helpful for traders on the go, as can non-brokerage data-focused apps, such as Stock Alarm. 

Backtest Your Trading Strategies

Don’t assume your trading strategies will automatically work. They may not. Instead, backtest them to see if they generate a profit when applied to historical data. If they don’t, you may need to refine your strategy. 

Practice on a Demo Account First

Avoid trading immediately with a live account. You’re very likely to make mistakes, in the beginning, so look into practicing on a demo (paper trading) account. This way, you can see whether your approach is successful before trading with real capital. 

Start Small

Don’t bet your life savings on your trading. Most professional traders only risk one to two percent of their net worth per day. 

The Bottom Line

So what is the technical analysis of stocks? Essentially, it’s about using price performance and trends to inform purchasing decisions. 

When deciding whether to use fundamental or technical analysis, consider your strengths and beliefs. If you are a highly analytical person who accepts the efficient market hypothesis, trading might be better. However, long-term investing may make more sense if you believe that fundamentals determine a security’s value.

Remember, you can use both fundamental and technical analysis. Many professional day traders use company fundamentals as context for their trading decisions.