What is Technical Analysis?

Technical analysis is a tool or process that uses market data to forecast securities' likely future price movement - such as a stock or currency pair.

As opposed to the fundamental analysis which utilises a companies financials such as revenue, profits etc., technical analysis uses the price, volume traded, historical movement of the the stock for the predictions.  

Understanding Technical Analysis

Technical analysis methods can be used to investigate how the demand and supply for specific securities affect price, volume, and implied volatility swings.

It is based on the notion that historical trading activity and price movements in the securities can be used as meaningful indications. When paired with appropriate trading or investment criteria, these indicators may aid in predicting market fluctuations in the future.

Using various charting tools, it is widely used to generate trade signals for short-term trading. They are, nevertheless, useful in improving the appraisal of a security's strength or weakness with respect to the greater market or its sector. Analysts use this information to help them enhance their overall assessment estimate.

Use of Technical Analysis

Professional analysts frequently employ technical analysis in conjunction with other sorts of studies.

Retail traders' decisions could only be based on price graphs and related statistics. Yet, equities analysts rarely rely just on technical or fundamental analysis. We can use technical analysis on any security with historical trading data.

Commodities, currencies, stocks, and other securities are examples of technical analysis. Technical analysis is often used in commodity and FX markets because traders are concerned with price movement in the near term.

Technical Stock Market Charts

A price chart, as you may know, is a series of prices plotted over a given timeframe. Technical charts can be created using any security that has price data over time.

Technical charts are classified into several varieties, including candlestick charts, line charts, open & high-low-close charts, and point & figure charts.

Indicators of Technical Analysis

More than a hundred patterns and indicators for trading in stock market technical analysis have been established by researchers from various businesses. Technical analysts have created a variety of trading methods to assist them in forecasting and trading price fluctuations.

These indicators are designed to identify current market trends, such as areas of support and resistance. Others are concerned with determining the strength of a trend.

Underlying Assumptions of Technical Analysis

There are three core assumptions of technical analysis that need to be kept in mind. 

The Market Discounts Everything

Technical analysis assumes that everything that is significant in relation to the stock is priced in or discounted. Hence, the price of a stock at any given time indicates every factor that may impact it and the company. These include fundamental aspects that are relevant to the organisation, market psychology, macroeconomic aspects, etc. Hence, this leaves analysts with only a single factor to closely evaluate- the price movement. 

Prices Follow a Trend

The second assumption is that stock price movements always follow trends. Technical strategies are based on the assumption that a stock’s future price movements are expected to be in the same direction as indicated by the trend itself. 

History Usually Repeats Itself

Another vital assumption is that history tends to repeat itself in relation to movements in stock prices. It is assumed that market psychology affects these movements in a repetitive/recurring manner. Hence, a stock price will react in a consistent manner over a period of time owing to similar provocations in the market. The historical stock price patterns are thus assumed to repeat themselves. 

Technical analysts thus track price changes and associated data like open interest, total outstanding contracts held at the end of each trading day, trading volumes, etc. They take help from many such consistent signals and patterns to support their analysis and predict price movements. Some of the key indicators include oscillators, chart patterns, price trends, moving averages, support and resistance levels, volume and momentum indicators, etc.

Fundamental Analysis vs Technical Analysis

Fundamental analysis looks into the underlying business performance, financial performance of a company, overall financial data, and appreciation potential. Hence, the focus here is more on the intrinsic value assessment of the company/entity behind a stock. 

At the same time, technical analysis is more geared towards mapping the historical market performance of the stock. This includes patterns, price trends, etc. It is more suited for short-term trading requirements, while fundamental analysis is more conducive for building a longer investment vision/horizon.  

Read More : Difference between Fundamental and Technical Analysis

Components of Trend Lines

Below mentioned are the key component of trend lines-

a) Trend Lines

The assumption underlying technical analysis is that prices trend. As a result, the employment of trend lines is critical for trend identification as well as trend confirmation.

A straight line is a trend line. It joins two or more price points and then continues into the future to serve as a support or resistance line. Trend lines are particularly beneficial for stock technical analysis.

b) Support and Resistance

Support and resistance are essentially price marks on a chart. These points are predicted to generate the greatest amount of buying or selling.

In technical analysis, the support price is the price at which there are more buyers than sellers. In the technical market, the resistance price is the price at which more sellers are expected than buyers.

c) Volume

Volume in technical stock analysis refers to the number of shares of a stock that are traded on a certain day or period of time.

Volume is critical since it validates previously determined trend directions. Volume is an important input. While studying stock charts, consider both price and volume.

Advantages and Limitations of Technical Analysis