Technical analysis

Quick definition

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Updated: Jan 10, 2024

Technical analysis is a market analysis technique that tries to ascertain the value of a security by focusing on market activity.

Key details

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  • Financial traders use technical analysis to predict future asset price changes
  • Technical analysis is based on price charts, using a range of information to forecast potential price changes
  • It’s generally a short term forecasting technique, as opposed to fundamental analysis which is a more long term strategy

What is technical analysis?

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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.

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.

Unlike fundamental analysis, technical analysis does not try to validate the intrinsic value of a stock. Instead, such analysis focuses on charts as analysts try to identify patterns as well as trends that suggest how the price will perform in the future.

Some of the factors looked at in technical analysis include:

  • Trading volumes
  • Historical share process
  • Industry trading trends

How does technical analysis work?

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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

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Technical analysis is based on three main assumptions:

The market ignores fundamental factors

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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.

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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

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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.

Example of a technical analysis strategy

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A technical analysis strategy comprises of a set of rules that define when a trader should take action, be it to enter or exit a position, depending on price patterns in the market. Most technical analysis strategies consist of trade filters and triggers that are based on various technical analysis indicators.

A trade filter identifies setup conditions, while trade triggers identify a particular time when an action is executed. A trade filter may involve paying attention to whenever a price moves above a given moving average, while a trade trigger might be whenever a stock’s price is about to breach the moving average.

The indicators that you use to develop a trading strategy will depend on which strategy you choose. For traders looking for long-term moves with large profits, a trend-following strategy using moving averages will make sense. A trader looking for smaller moves with frequent gains would focus on volatility indicators.

While developing a technical analysis strategy, it is important to consider a number of different points. Those include:

  • The type of moving average being used
  • How far above or below the moving average a price should move to enter or exit a position
  • What type of order to place whenever market conditions are met
  • How many contracts or shares to trade
  • What are the exit rules

Technical analysis vs. Fundamental analysis

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When choosing which methodology to deploy, it is important to consider your overall investment strategy. Fundamental analysis is an ideal methodology for investors looking for long-term investments. Technical analysis, on the other hand, would be best suited for short-term investments.

By focusing on fundamentals likely to influence intrinsic value, then investors are essentially trying to predict how the security would perform in the future. In contrast, focusing on market trends, technical analysts try to predict price movements in the short term.

ComparisonFundamental analysisTechnical analysis
MeaningPractice of analyzing securities’ intrinsic valuePractice of predicting future price by relying on stock charts to identify patterns and trends
RelevanceLong-term investmentsShort-term investments
Decision MakingDecisions made based on underlying fundamentalsDecisions based on market trend and price patterns
Data For Decision MakingEconomic reports, earnings reports, management, industry trendsCharts only
Focuses onPast and present dataPast data only

Fundamental analysis is best suited for longer-term investors as it focuses on longer periods as a way of ascertaining long-term value. In contrast, technical analysis is best suited for traders looking to make short-term profits based on price movements.

Sources & references
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James Knight
Editor of Education
James is the Editor of Education for Invezz, where he covers topics from across the financial world, from the stock market, to cryptocurrency, to macroeconomic markets.... read more.