Technical Analysis is the forecasting of future financial price movements based on an examination of past price movements. Like weather forecasting, technical analysis does not result in absolute predictions about the future.
Technical analysis uses a wide variety of charts that show price over time. Technical analysis is applicable to stocks, indices, commodities, futures or any tradable instrument where the price is influenced by the forces of supply and demand.
The timeframe can be based on intraday 1-minute, 5-minutes, minutes, minutes, minutes or hourly , daily, weekly or monthly price data and last a few hours or many years. Technical analysis is applicable to securities where the price is only influenced by the forces of supply and demand.
Technical analysis does not work well when other forces can influence the price of the security. In order to be successful, technical analysis makes three key assumptions about the securities that are being analyzed:. It is important to determine whether or not a security meets these three requirements before applying technical analysis.
That's not to say that analysis of any stock whose price is influenced by one of these outside forces is useless, but it will affect the accuracy of that analysis. At the turn of the century, the Dow Theory laid the foundations for what was later to become modern technical analysis. Dow Theory was not presented as one complete amalgamation, but rather pieced together from the writings of Charles Dow over several years.
Of the many theorems put forth by Dow, three stand out:. This theorem is similar to the strong and semi-strong forms of market efficiency. Technical analysts believe that the current price fully reflects all information. Because all information is already reflected in the price, it represents the fair value, and should form the basis for analysis.
After all, the market price reflects the sum knowledge of all participants, including traders, investors, portfolio managers, buy-side analysts, sell-side analysts, market strategist, technical analysts, fundamental analysts and many others. It would be folly to disagree with the price set by such an impressive array of people with impeccable credentials. Technical analysis utilizes the information captured by the price to interpret what the market is saying with the purpose of forming a view on the future.
Most technicians agree that prices trend. However, most technicians also acknowledge that there are periods when prices do not trend. If prices were always random, it would be extremely difficult to make money using technical analysis. In his book, Schwager on Futures: Technical Analysis , Jack Schwager states:. The goal of the chartist is to identify those periods i.
A technician believes that it is possible to identify a trend, invest or trade based on the trend and make money as the trend unfolds. Because technical analysis can be applied to many different timeframes, it is possible to spot both short-term and long-term trends. The IBM chart illustrates Schwager's view on the nature of the trend. The broad trend is up, but it is also interspersed with trading ranges. In between the trading ranges are smaller uptrends within the larger uptrend.
The uptrend is renewed when the stock breaks above the trading range. A downtrend begins when the stock breaks below the low of the previous trading range.
Technicians, as technical analysts are called, are only concerned with two things:. The price is the end result of the battle between the forces of supply and demand for the company's stock. The objective of analysis is to forecast the direction of the future price.
By focusing on price and only price, technical analysis represents a direct approach. Fundamentalists are concerned with why the price is what it is. For technicians, the why portion of the equation is too broad and many times the fundamental reasons given are highly suspect.
Technicians believe it is best to concentrate on what and never mind why. Why did the price go up? It is simple, more buyers demand than sellers supply. After all, the value of any asset is only what someone is willing to pay for it. Who needs to know why? Many technicians employ a top-down approach that begins with broad-based macro analysis.
Such an analysis might involve three steps:. The beauty of technical analysis lies in its versatility. Because the principles of technical analysis are universally applicable, each of the analysis steps above can be performed using the same theoretical background.
You don't need an economics degree to analyze a market index chart. You don't need to be a CPA to analyze a stock chart. It does not matter if the timeframe is 2 days or 2 years.
It does not matter if it is a stock, market index or commodity. The technical principles of support, resistance, trend, trading range and other aspects can be applied to any chart.
While this may sound easy, technical analysis is by no means easy. Success requires serious study, dedication, and an open mind. Technical analysis can be as complex or as simple as you want it. The example below represents a simplified version. Since we are interested in buying stocks, the focus will be on spotting bullish situations.
The first step is to identify the overall trend. For example, the trend is up as long as price remains above its upward sloping trend line or a certain moving average.
Similarly, the trend is up as long as higher troughs form on each pullback and higher highs form on each advance. Areas of congestion and previous lows below the current price mark the support levels. A break below support would be considered bearish and detrimental to the overall trend. Areas of congestion and previous highs above the current price mark the resistance levels. A break above resistance would be considered bullish and positive for the overall trend. Momentum is usually measured with an oscillator such as MACD.
If MACD is above its 9-day EMA exponential moving average or positive, then momentum will be considered bullish, or at least improving. For stocks and indices with volume figures available, an indicator that uses volume is used to measure buying or selling pressure.
When Chaikin Money Flow is above zero, buying pressure is dominant. Selling pressure is dominant when it is below zero. The price relative is a line formed by dividing the security by a benchmark.
The plot of this line over a period of time will tell us if the stock is outperforming rising or underperforming falling the major index. For each segment market, sector, and stock , an investor would analyze long-term and short-term charts to find those that meet specific criteria.
If the broader market were considered to be in bullish mode, analysis would proceed to a selection of sector charts. Those sectors that show the most promise would be singled out for individual stock analysis.
Once the sector list is narrowed to industry groups, individual stock selection can begin. With a selection of stock charts from each industry, a selection of of the most promising stocks in each group can be made.
How many stocks or industry groups make the final cut will depend on the strictness of the criteria set forth. Under this scenario, we would be left with stocks from which to choose. These stocks could even be broken down further to find the of the strongest of the strong.
If the objective is to predict the future price, then it makes sense to focus on price movements. Price movements usually precede fundamental developments. By focusing on price action, technicians are automatically focusing on the future. The market is thought of as a leading indicator and generally leads the economy by 6 to 9 months. To keep pace with the market, it makes sense to look directly at the price movements.
More often than not, change is a subtle beast. Even though the market is prone to sudden knee-jerk reactions, hints usually develop before significant moves. A technician will refer to periods of accumulation as evidence of an impending advance and periods of distribution as evidence of an impending decline. Many technicians use the open, high, low and close when analyzing the price action of a security.
There is information to be gleaned from each bit of information. Separately, these will not be able to tell much. However, taken together, the open, high, low and close reflect forces of supply and demand. The annotated example above shows a stock that opened with a gap up.
Before the open, the number of buy orders exceeded the number of sell orders and the price was raised to attract more sellers. Demand was brisk from the start. The intraday high reflects the strength of demand buyers. The intraday low reflects the availability of supply sellers. The close represents the final price agreed upon by the buyers and the sellers.
In this case, the close is well below the high and much closer to the low. This tells us that even though demand buyers was strong during the day, supply sellers ultimately prevailed and forced the price back down.More...