Solskin / Getty Images A basic understanding of the underlying principles and tools used when conducting technical analysis can help you improve your investment research.
What Is Technical Analysis?
The creation of technical analysis is largely credited to Charles Dow, co-founder of The Wall Street Journal and the Dow Jones Industrial Average. Instead of analyzing a company’s dynamics, such as its balance sheet or corporate structure, technical analysis uses price and volume data to attempt to predict future security prices. Price refers, simply, to how much a single share of a security costs, while volume is the number of shares of a security that are traded in a given time frame, such as a day. Various types of price charts are used in technical analysis to analyze price and volume, from which technical indicators are derived that can suggest patterns in the stock’s movement and signal whether to buy or sell.
How Technical Analysis Works
There are three main tenets of technical analysis:
Market Action Accounts for Everything
The first tenet of technical analysis is a basic belief that the efficient markets hypothesis is correct. This means that all available information about a stock’s value is reflected in the stock’s price. When new information that would affect the value of a stock becomes available, it is quickly and completely absorbed by the market and reflected in its price.
Prices Move in Trends
The second basic tenet relies on a belief that prices will continue to move in the same direction until a technical indicator suggests a reversal. There are many different technical indicators, and the specific one chosen is up to the individual investor. The idea here is to identify and follow the trend until it shows signs of reversing. For example, if the price has been rising, but now the technical indicator suggests it will start to fall, an investor may choose to sell that security.
History Repeats Itself
The final tenet of technical analysis is that historical patterns in stock price movements tend to repeat themselves. This element of technical analysis relies on market psychology to interpret patterns in price charts. Market psychology is the collective sentiment of all investors, and the belief here is that this is what drives the ups and downs in security prices. When investors are optimistic about a security, they will buy it and push the price up. When that optimism falls, they will sell and the price will fall.
Methods of Technical Analysis
As previously mentioned, technical analysis involves the study of past market activity to identify a trend in a security’s price. There are many types of technical indicators, and most technical analysis practitioners, called chartists or technicians, will incorporate more than one indicator to make an investment decision. Some examples of technical indicators include:
Bollinger Bands
Bollinger Bands compare the current moving average price of the security with the standard deviation of that same moving average. The current moving average is the moving average at the time of comparison. Standard deviation is a measure of how much a value fluctuates around its average; bands plotted above and below the moving average are called Bollinger Bands and are based on standard deviation. Typically, the bands will be set at two standard deviations above and below the 20-day moving average. When a chartist sees the bands tighten, or come closer together, this suggests that a trend may be forming. If the trend is positive, an investor could buy the security to follow the trend up. If the distance between the bands widens, the trend may be ending, at which point the investor would sell. The strength of the trend is anticipated to be very strong if the moving average goes outside one of the bands.
Average Volume
The average volume is a simple moving average of the number of shares exchanged for the chosen time period. For example, you may calculate the average daily volume over the preceding 60 days. When the recent volume exceeds the moving average volume, this suggests greater strength of a trend. For example, if the price has been climbing and the recent volume is well above the average volume, that is taken as a sign of a strong trend—an investor might choose to purchase or increase their holdings. If the recent volume is below the average moving volume, then the trend is viewed as weaker.
MACD
Moving average convergence/divergence (MACD) compares the 26-period exponential moving average price with the 12-period exponential moving average of the same price. You can approximate the MACD line by subtracting the 26-period exponential moving average from the 12-period exponential moving average and plotting the resulting value. To use the MACD, you compare it to a signal line, which is the nine-period exponential moving average of the MACD line. If the MACD line moves above the signal line, it indicates a bullish trend; an investor using this indicator would buy the security. The MACD line dropping below the signal line identifies a negative trend, in which case an investor might sell.
Alternatives to Technical Analysis
Fundamental analysis is another method of evaluating investment decisions. It can be used by itself or in conjunction with technical analysis. Fundamental analysis considers the value of the business entity to make investing decisions, rather than historical stock price patterns. The value of the company’s assets, debt, and operational performance issues, such as profitability and cash flow, are relevant data for conducting fundamental analysis. This information can be gleaned from the quarterly and annual financial statements, to include the income statement, balance sheet, and cash flow statement.
