Educational

Technical Analysis: Importance and Basics

Technical Analysis is an analysis method for predicting the direction of prices through the study of previous market data, primarily price and volume. Moreover, technical analysis is a trading discipline employed to assess investments and identify chances by analyzing statistical trends collected from trading movement, such as price movement and volume.

TECHNICAL ANALYSIS word Closed up finger on keyboard.

Technical analysis may appear complex on the surface, but it comes down to an analysis of supply and demands in the market figure out where the price trend is going.

Technical analysis is relevant to stocks, indices, commodities, futures or any tradable tool where the cost is affected by the forces of supply and demand. Price data refers to any combination of the open, high, low, close, volume, or open interest for a given security over a particular timeframe. The timeframe can be founded on intraday, daily, weekly or monthly price data and last a few hours or numerous years.

The hypothesis behind the validity of technical analysis is the idea that the collective actions – buying and selling – of all the participants in the market precisely replicate all important information refer to a traded security, and therefore, continually allocate a fair market value to the security.

Technical analysis might be compared with fundamental analysis, which centers on a company’s financials instead of historical price patterns or stock trends. In fact, technical analysis is far more widespread in commodities and forex markets where traders focus on short-term price activities.

Key Assumptions of Technical Analysis

Technical analysis is relevant to securities where the price is only affected by the forces of supply and demand. Technical analysis does not function well when other forces can affect the value of the security. In order to be successful, technical analysis makes three keys assumptions about the securities that are being analyzed:

High Liquidity

Liquidity is basically volume. Heavily-traded stocks enable investors to trade fast and easily, with no dramatically changing the value of the stock. Thinly-traded stocks are more hard to trade, because there aren’t numerous purchasers or sellers at given time, so purchasers and sellers may have to change their wanted price considerably in order to make a trade.

Moreover, low liquidity stocks are often very low valued, which means their values can be more easily controlled by individual investors. These outside forces acting on thinly-traded stocks make them inappropriate for technical analysis.

No Artificial Price Changes

Splits, dividends, and distributions are the most common “culprits” for artificial price changes. However, there is no difference in the value of the investment, artificial price changes can dramatically influence the price chart and make technical analysis hard to apply. This type of price influence from outside sources can be easily addressed by adjusting the historical data prior to the price change.

History repeats itself

Technical analysis cannot foresee risky events, including business events such as a company’s CEO failing unexpectedly, and political events such as a terrorist act. When the forces of “extreme news” are affecting the price, technicians have to wait patiently until the chart settles down and begins to replicate the “new normal’ that results from such news.

It is significant to determine whether or not a security encounters these three requirements before applying technical analysis. That’s not to say that analysis of any stock whose price is affected by one of these outside forces is useless, but it will affect the accuracy of that analysis.

The Basic of Technical Analysis

Now that you know a bit more about technical analysis and the suppositions behind it, let’s cover some of the basic ideas in technical analysis. All of these ideas can be a full article on its own, but for now we’ll just run through the most important facts to get you started.

Candlestick chart on laptop screen.

Price

Price is represented in some different ways, depending on the kind of chart you’re using. There are bar charts, in which price is represented by a bar. Candlestick charts, in which price is represented by what resembles a candlestick, as you can see on the graphics in the middle and the right; and line charts, where price is nothing more than, well, a line.

Support and resistance

Support and resistance are two of the most basic ideas in technical analysis. You can now utilize them to make trading choices, however they also form the foundation of more complicated strategies and trading systems.

Support

Support is the price that, generally, a stock has had difficulty falling lower. This is where the market considers the price to be “low-cost”. Demand becomes so strong that it prevents the price from going any lower.

Resistance

Resistance is solely the inverse of support. This is where the stock price usually begins going down because there is an excessive supply and insufficient demand.

Trend button pointing the word follow over dark grey and blue background.

Trend Analysis

There are continually going to be ups and downs in the stock market and in each stock, but these ups and downs will finally form a trend that moves in some overall directions—this is actually one of the important assumptions of technical analysis.

Volume

Many technical analysis involves study the stock price, but that’s not the only significant statistic in technical analysis. Another equally significant, if not more significant, number to look at is the trading volume.

The trading volume tells you the quantity of shares that were purchased and sold in a specific time frame (usually a day). You can see the volume shown as a bar graph at the bottom of the stock chart.

Chart Patterns

There are a lot of types of charts that traders can utilize to monitor the stock market, but the most popular is maybe the candlestick chart.

Moving Averages business Term with Climbing Chart.

Moving Averages

There are many types of moving averages used in technical analysis, but they all have one purpose—to eliminate day-to-day price fluctuations and make chart analysis easier. Moving averages enable us to plot smoother lines that show trends and patterns more clearly.

Past Price as an Indicator of Future Performance

Technical traders believe that existing or previous price action in the market is the most dependable indicator of future price action.

Technical analysis is not only used by technical traders. A lot of fundamental traders utilize fundamental analysis to determine whether to purchase into a market, but having made that choice, then utilize technical analysis to pinpoint good, low-risk buy entry price levels.

Fundamental VS Technical Analysis

An investor is presenting about fundamental analysis of stock.

Fundamental Analysis

The Fundamental analysis is the methodology whereby one attempts to calculate the inherent value of a stock by study the basic financial factors, the fundamentals, which would influence its value. Pertinent factors that will be looked at include:

  • Profits, expenses and earnings
  • Development predictions for the firm
  • The competitive factors the firm faces
  • Expected return on equity or assets in the business

The objective of this analysis is to establish a value for the stock that would factor in all of these underlying factors. As the methodology doesn’t look at short term pricing and trading swings this is considered a long term investment method, as it might take time for the inherent value to be understood. As this factors in onward looking expectations this method is considered to construct a valuation based on backward and forward looking data.

Technical Analysis

Technical analysis is an investment method that assesses investments purely on the market movement close to them, without looking to the actual operations or value of the company itself. Pertinent factors that will be looked at include:

  • Historical pricing of the shares
  • Trading volumes over time
  • Industry trading trends

The objective of this analysis is to capitalize on pricing chances and trends that can be recognized in the market movement around each share. As the method is only based on past market movement this is considered to be a backward looking method.

When it comes to comparing and selecting a method between the two there are two important considerations to factor in.

First, the time horizon of your methodology is important to consider. Fundamental analysis is a long term investment strategy while technical analysis is considered far further of a short term method. By pricing on basic values fundamental analysis is working to the long-term value of a business, whereas by trading on market trends technical analysis is short-term focused.

Conclusion

Technical analysts view the market 80% psychological and 20% logical. Fundamental analysts view the market 20% psychological and 80% logical. Psychological or logical might be open for discussion, but there is no questioning the existing price of a security.

Keep in mind the fact that no technical indicator is perfect. None of them gives signals that are 100% accurate all the time.

The experts’ traders are always watching for warning signs that signals from their selected indicators may be misleading. Technical analysis, done well, can certainly develop your profitability as a trader. Nonetheless, what might do more to develop your lucks in trading is spending more time and effort thinking about how best to handle things if the market turns against you, instead of just fantasizing about how you’re going to spend your millions.

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