Technical analysis is one of the many tools used by investors, financial advisors, and other professionals to make educated investment decisions.
Technical analysis uses historical price data about an asset (stock, bond, currency, futures contract) to forecast its future price movements. Technical analysts believe that price movement is caused by external factors which influence supply and demand for a particular asset. Detractors argue that insufficient evidence supports technical analysis to justify its usefulness as a forecasting tool. However, it remains popular amongst some traders because it can be a helpful supplement alongside traditional strategies such as fundamental or quantitative analysis.
What does being “technical” mean?
The term “technical” means related to technicians – people who have the training and skills to do a job. In technical analysis, it refers to using specific tools that technicians use when they work on equipment or machines.
Technical analysis tools
There are various types of graphs used in technical analysis, including:
- Line charts
- Bar charts
- Candlestick Charts
- Open-high low-close (OHLC) chart
- Point and figure chart
- Area charts
- Renko chart
Some tools can assist with developing market trends, such as
Moving averages: Bollinger bands Technical analysts argue that many fundamental analysts fail to appreciate the role played by supply and demand in market movements because there is no economic data available about their impact. Rather than analyzing macroeconomic events such as interest rates or inflation, technical analysts prefer to focus on microeconomics which involves analyzing the price movements of individual securities.
How is it used?
Technical analysis can be used in three different ways:
- By trading professionals who use charts to develop and test their trading strategies;
- By traders who use technical analysis as a supplement alongside other techniques;
- Investors may use technical indicators to generate hypotheses about future stock prices but make investment decisions based on fundamental factors.
Technical analysts generally believe that it is possible to identify market trends by analyzing past price patterns. They claim that this method has several advantages over traditional approaches like quantitative analysis (which tries to value assets based on complex mathematical models). Foremost among these are its simplicity and its adaptability to different market conditions.
Technicians argue that fundamental factors are difficult to forecast because they are often delayed and subject to ongoing revisions. As a result, any analysis of fundamental factors which is based on future expectations is inherently unreliable. This point of view is also held by investors who use technical analysis as a complement rather than a standalone approach because it helps them understand the price drivers which could cause an asset’s price to fall or rise in the short term.
Technical indicators & trading strategies
Technical indicators are derived from historical data about past prices for an asset, but there is no standard method for this process. The lack of uniformity means it can be difficult for beginners to determine whether technical indicators have been applied correctly or incorrectly.
Each indicator uses its own set of rules to create buy and sell signals or trade recommendations. As well as using price data, technical analysts can also use volume data to back-test their trading strategies. By analyzing the volume of trading activity for an asset, they can determine whether the past performance was due to strong market interest or not.
Technical analysis has become so widely used that numerous books offer basic tutorials on how investors can use it to make better investment decisions. For example, A technician may use the Relative Strength Index (RSI) to determine if momentum is bullish or bearish. The RSI compares an asset’s recent trading prices to its historical price range. If the most recent closing price is higher than the lowest in the last 13 periods, it would be considered overbought, and a sell signal would be generated.
On the other hand, if it has dropped below its highest closing price from the previous 52 weeks, an oversold condition exists, and a buy signal is generated.