Technical analysis is a trading discipline that involves studying and analysing past market data with a view of predicting future price movements. It differs a great deal from fundamental analysis, which entails trying to evaluate the intrinsic value of a security.
Technical analysis as a methodology of trading focuses on price movements as well as trading signals, among other charting tools. The aim is to try and evaluate the strength and weaknesses of a given asset while relying solely on past price movements and trading volume.
Over the years, it’s been proven that past trading activities, as well as price movements, have a significant impact on future price movements, regardless of the security under study. While some analysts rely on technical analysis independently, others combine it with fundamental analysis to get a clearer view of the worthiness of a stock.
How technical analysis works
Technical analysts spend a good chunk of their time analysing price charts to try and identify key technical signals, in the form of support and resistance levels. That in-depth analysis makes it possible to understand why price moved in a given direction, and how it’s likely to move in the future.
While analysing charts, technical analysts rely on various indicators to estimate price movement. Some of the most commonly used indicators include moving average convergence divergence (MACD), trading volume history, and the Relative Strength Index (RSI).
Intraday technical analysts spend a good chunk of their time analysing 5- and 15-minutes charts, while long-term traders specialise in longer-timeframe charts, such as hourly, daily, and weekly charts.
Technical analysis assumptions
Technical analysis is based on three main assumptions:
The market ignores fundamental factors
Most technical analysts ignore fundamental factors such as financial reports when predicting price movements. Instead, technical analysts maintain the notion that any emerging piece of fundamental information is already priced into the stock. By doing so, technical analysts can focus solely on price movements and volume signals.
Price moves in trends
Analysts that specialize in technical analysis see the prices of securities moving in short, medium, and long-term trends. Likewise, whenever a given trend is in play, the price of the security will move in that direction until a new trend is established. Hence, plenty of short-term and long term traders rely on chart patterns to place trades.
History repeats itself
The notion that history repeats itself is one of the reasons why technical analysis pays close attention to past price movements. The repetitive nature of price movement is based on the fact that market psychology, in the form of fear and greed, tends to be very predictable…in every era.
Technical analysis makes it possible to identify the best entry and exit points, by focusing on past price movements. However, it is important to note that unpredictable market behaviour can happen sometimes. It’s therefore important to consider other analysis methodologies such as fundamental analysis to give you a more complete view of the market, especially if you’re looking for longer-term results.