Every day the financial markets open, traders log into their brokerage accounts and attempt to profit from the various price fluctuations of listed assets. Trading in these financial markets is a challenging task that very few traders can complete successfully. In reality, most traders who attempt to make an income from trading will ultimately end with less money than they started. To increase the odds of success in their favor, traders regularly employ the use of technical analysis to help them identify optimal entry and exit points from their trades.
This guide will seek to examine the foundations of technical analysis for those of you who are just embarking on your trading careers. It will cover the strengths and limitations of technical analysis, its foundational principles, and how technical analysis works. Let’s get started!
What is Technical Analysis?
Technical analysis is a method of trading that employs the use of data points to determine whether the price of an asset will rise or fall. These data points can come from several different sources such as chart patterns, indicators, the volume of shares, and price action. Traders analyze these data points in an attempt to determine the probability of an asset rising or falling in price and then enter their trades accordingly.
How Does Technical Analysis Work in the Stock Market?
The temple of technical analysis is built almost exclusively on human psychology. As a result, many new traders often wonder why a particular pattern appearing on a chart or an indicator hitting an arbitrary metric would influence the price of an asset? Let’s explore this in more detail.
In the stock market, only two forces truly move the price of an asset; supply and demand. If there is more demand for a stock than there is supply, the value of that stock will rise. Conversely, if there is more supply for that stock than there is demand, the value of that stock will fall. So, how does technical analysis work?
Every day, traders scan the markets looking for opportunities to trade. Each one of these traders examines the same charts, patterns, price movements, and indicators as every other trader. As a result, traders use the same information to inform their decision-making; this is the basis of technical analysis.
When traders examining a chart believe that the price of an asset will fall, they enter positions to benefit from that asset declining in value. If enough traders enter positions to sell, the selling pressure will drive the price of that asset down. When the value falls, traders herald the benefits of technical analysis as it once again proves its worth. In short, technical analysis is a self-fulfilling prophecy. It works because traders believe it will and make decisions based on that belief.
- Entry/Exit - Technical analysis can help investors to identify better entry and exit points for their investments in the short term.
- Transferability - Traders can use technical analysis on a wide range of assets and can use it to inform their investment decisions whenever necessary.
- Short Term - Technical analysis is often useful in the short term to identify potential opportunities to profit from price movements.
- Accuracy - Technical analysis is far from an exact science and often relies upon the subjective judgment of each individual trader. This is because individual traders can interpret the same data points in different ways.
- Complexity - Unlike buying and holding index funds, technical analysis is not a simple skill to master. Learning to accurately analyze technical data can often take years and is therefore not suitable for the average investor.
- Long-term - Technical analysis becomes increasingly unreliable as time goes on. Therefore, it has no utility for long-term investors interested in making investments with long time horizons.
Where Does Technical Analysis Apply?
Thankfully, technical analysis applies to all assets with historical price data which trade on public markets. As a result, technical analysis applies to a wide variety of asset classes that include stocks, cryptocurrencies, forex, and commodities.
However, traders should note that the reliability of their technical analysis will fluctuate depending on the specific asset they choose to trade. For example, obscure cryptocurrencies with low liquidity may not be ideal grounds for technical analysts to apply their skills as the results of their technical analysis are not likely to be reliable.
When to Use Technical Analysis
As we noted above, one of the failings of technical analysis is its declining utility as time goes on. Therefore, traders should only apply technical analysis to short-term trades where they are seeking to benefit from price fluctuations.
Alternatively, some technical analysts may use technical analysis to determine when they should add to their positions. For example, a long-term investor in Apple (AAPL) may wish to add to his position but delay the additional investment based on technical data.
However, new investors must know they should not be using technical analysis to form the basis of their long-term investment decisions. When deciding whether to invest in a company for the long term, investors should explore the fundamentals of the company. We will discuss the differences between technical and fundamental analysis in the section below.
Principles of Technical Analysis
Technical analysts believe that the market price of an asset reflects all available and relevant data. In accordance with this belief, technical analysis is founded on the following three principles:
- Market Discounts - Sooner or later, the financial markets go on sale and the prices of securities fall below their true value.
- Price Fluctuations - The prices of assets move in accordance with trends and counter-trends. If an asset class is trending down, the price will likely fall in the short term regardless of its fundamentals.
- History Repeats - The prices of assets fluctuate daily causing patterns to form on charts. The patterns are repetitive and can be used to inform trading decisions.
Technical analysis vs Fundamental Analysis
If conducting a technical analysis is the study of price charts and data points to determine future price action, what is fundamental analysis? Fundamentalists believe in examining the specifics of a company. They access the company's financial statements, business model, management team, and other metrics such as sales, revenue, and net profits to determine whether they should invest in an asset.
The question most readers will naturally be asking is, which one is better? The debate over which trading methodology is best is an ongoing one. Supporters of each methodology regularly denounce the merits of the other and far too often misunderstand that each of these trading philosophies has its place.
Generally, technical analysis is used for short-term trades that attempt to time the market and identify optimal entry and exit points. Adopters of technical analysis would either be day traders or long-term investors trying to identify the best times to add more shares to their positions.
Fundamental analysis is essentially the polar opposite of technical analysis. It can and should be used to invest in assets when the intention is to hold them over long periods of time. As such, whether you use technical or fundamental analysis depends on your personal investment goals and the time frame you intend on being invested for.
How to Use Technical Analysis
Now that you know what technical analysis is, you may be curious to know how you can use it to successfully trade in the financial markets. In order to use technical analysis, traders will need access to a charting platform, indicators, and pattern recognition software. In the digital age, all of this is available online and can be easily accessed with little more than a laptop and an internet connection. If you are interested in learning how to use technical analysis, check out our article here!
Yes! Cryptocurrencies have historical price data and trade on public markets. As a result, you can use technical analysis when trading cryptocurrencies. However, inexperienced traders should note that cryptocurrencies are considerably more volatile than other assets. This makes them much more challenging to trade successfully and by extension, extremely high-risk.
Traders who have employed the use of technical analysis when trading in the financial markets can be profitable. However, it should be noted that learning to conduct technical analysis is no easy task and would-be traders should prepare to spend months or even years learning how to apply technical analysis in the financial markets.
There are a number of free resources available on the internet that can provide valuable information for those of you who are keen to learn about technical analysis. Blogs, YouTube videos, and Reddit forums are great in number and easy enough to find. Further, there are several well-respected books on technical analysis available online.