What is Technical Analysis?
Technical Analysis is a method of financial market analysis that predicts future price movements by statistically and graphically analyzing historical data such as prices, trading volumes, and indicators.
The core principle of technical analysis is that the market reflects everything. It posits that all information is already reflected in the prices, and by analyzing price patterns, chart forms, and indicators, one can reveal key information like market trends, price supports and resistances, and buy and sell signals to aid investment decisions. Technical analysis relies on several key concepts and tools.
- Chart Patterns: Technical analysis uses various price charts, such as line charts, candlestick charts, and point and figure charts, to display historical price trends and patterns. Common chart patterns include trend lines, support and resistance levels, and chart formations like head and shoulders and double bottoms.
- Technical Indicators: Technical analysis employs various mathematical formulas to calculate indicators of price and volume to assist in predicting price trends. Common technical indicators include moving averages, Relative Strength Index (RSI), and stochastic oscillators.
- Trade Signals: Technical analysis issues buy or sell signals based on changes in chart patterns and technical indicators. These signals might include price breakthroughs of support or resistance levels, indicator crossovers, or breaks in overbought or oversold regions.
Three Major Assumptions of Technical Analysis
Technical analysis is based on three main assumptions, which form the theoretical foundation of the methodology.
- Market Reflects Everything: The first assumption is that the market reflects all available information. This means that all resources, including fundamental information and market psychology, are already reflected in the price trends. Analysts believe that by examining price and volume, one can identify price patterns and trends and thus predict future price movements.
- Prices Move in Trends: The second assumption is that price movements follow trends. Analysts believe that price trends are pervasive and continuous in the market. By observing price charts and trendlines, investors can identify and follow these trends to profit within them.
- History Tends to Repeat Itself: The third assumption is that history repeats itself. Analysts believe that market behaviors will somewhat repeat, and therefore historical market data and price patterns can help predict future price movements.
Although these three assumptions provide a theoretical basis for technical analysis, they are not irrefutable. The efficiency, trendiness, and repetitiveness of markets are debated in academia, and market behaviors can be influenced by a variety of factors.
Characteristics of Technical Analysis
As one of the more commonly used and more easily mastered methods of financial market analysis, technical analysis has the following characteristics:
- Based on Historical Data: Technical analysis relies on past market data, including prices, trading volumes, and indicators. By analyzing historical data, analysts attempt to discover patterns and trends in price movements and predict future trends.
- Focus on Price and Chart Patterns: The primary focus of technical analysis is the changes in prices and the patterns on price charts. Analysts use various chart forms and indicators to analyze price trends, support and resistance levels, and other key price points.
- Aid in Decision Making: Technical analysis provides methods for determining buy and sell times, and setting levels for stop-loss and take-profit, making it widely used in supporting investment decisions.
- Consideration of Market Psychology: Technical analysis believes market prices are influenced by market psychology. By observing price trends and trading volumes, analysts try to understand the psychological state of market participants and make predictions accordingly.
- Suitable for Short-Term Trading: Since technical analysis focuses on price trends and short-term patterns, it is more suitable for short-term trading and speculation.
- Subjectivity: Different analysts might interpret the same data differently based on their own experiences and preferences, leading to varying opinions and strategies in practice.
Common Indicators in Technical Analysis
Technical analysis uses various indicators to assist in analyzing market prices and trends. Here are some commonly used technical indicators:
- Moving Averages: Moving averages are lines calculated based on average prices over a certain period, helping to determine the price trend and support and resistance levels. Common moving averages include Simple Moving Average (SMA) and Exponential Moving Average (EMA).
- Relative Strength Index (RSI): RSI measures the intensity and speed of price changes. It shows the overbought and oversold status of prices and helps determine if the market is overly bought or sold.
- Stochastic Oscillator: This indicator compares the current price to a range of prices over a period to determine the overbought and oversold status and helps predict price reversals.
- Volume Indicators: Volume indicators analyze trading volume changes; common volume indicators include volume histograms and Volume-Weighted Moving Average (VWMA).
- Momentum Indicators: These measure the momentum and speed of price movements. Common momentum indicators include RSI and Moving Average Convergence Divergence (MACD).
- Divergence Indicators: These are used to find divergence signals between price trends and technical indicators, which often indicate upcoming changes in price trends.
- Bollinger Bands: Bollinger Bands consist of a middle line and upper and lower standard deviation lines, used to measure price volatility and help determine price ranges and trends.
Technical Analysis vs. Fundamental Analysis
Technical analysis and fundamental analysis are two common investment analysis methods, differing in data sources, analysis objects, and methods.
- Data Sources: Technical analysis relies mainly on statistical and chart analysis of historical market data to predict future price movements. Fundamental analysis focuses more on basic company and economic data, such as financial statements, industry data, and economic indicators.
- Analysis Focus: Technical analysis centers on market prices and price trends, making decisions by observing price charts and indicators. Fundamental analysis, on the other hand, evaluates a company's intrinsic value and profitability, as well as the impact of macroeconomic factors on the company and industry.
- Methods and Tools: Technical analysis uses various chart patterns, technical indicators, and price trendlines for analysis, relying on shapes, crossovers, and breakouts in charts and indicators to judge market trends and trading opportunities. Fundamental analysis uses financial ratios, valuation models, industry analysis, and economic indicators to evaluate a company's financial condition, growth potential, and valuation level.
- Time Frame: Technical analysis focuses on short-term price trends and patterns, making it more suitable for short-term trading and speculation. Fundamental analysis is more suited to long-term investment and value investing, requiring in-depth research into a company's financial and operating conditions and evaluating its profitability and long-term growth potential.
- Considerations: Technical analysis primarily considers market prices and market psychology, believing that price trends and patterns reflect participants' emotions and behaviors. Fundamental analysis considers a company's finances, performance, competitive environment, management team, and macroeconomic factors affecting the industry and company.
In summary, technical and fundamental analyses are not mutually exclusive. Technical analysis provides short-term trading opportunities and trend judgment, while fundamental analysis offers a more comprehensive company valuation and long-term investment basis. Combining both methods can provide a more thorough and accurate investment decision support.
