What is Technical Analysis?
Technical analysis is a form of stock analysis that focuses on analysing past movements in stock prices. It has two aims: to determine whether the current price represents good value, and to predict future price movements. Here, learn what technical analysis is and what strategies you could take.
Technical analysis is one of the two main schools of thought in stock analysis, a discipline that seeks to establish whether the current price of a stock represents good value or not.
Technical analysis focuses on historic stock-price movements while fundamental analysis, the other form of stock analysis, looks at economic, political, regulatory, competitive and human factors, which could influence the fortunes of a business and, therefore, its stock price.
Technical analysis is based on the idea that by looking at previous stock-price movements, it is possible to get a good idea of where the price will go in the future.
Short- to long-term price charts
Traders use price charts to try to forecast future movements. They use time frames ranging from a minute to a year, although most use charts whose time frames range from five minutes to a day.
The type of chart used will depend on the strategy a trader is employing. Day traders, who seek to profit from short-term fluctuations in stock prices, tend to focus on short timeframes. Meanwhile, traders who prefer to hold a position overnight, or ‘buy and hold’ investors (who may hold an investment for years), use charts with longer timeframes.
The other main variable involved in technical analysis is the type of technical indicator a trader prefers to employ.
The moving average is the technical indicator that is most commonly used to determine the direction in which a share price is likely to move. Moving averages are calculated by adding up all the prices during a specific period of time and dividing the sum by the number of individual data points. The moving average constantly updates as time passes and can cover any time period the trader wishes, from a minute to a week, a year or beyond.
Other commonly used technical indicators or metrics include:
- The Arms Index: Also called the Short-Term Trading Index (TRIN), this index compares the number of advancing and declining stocks with the advancing and declining volume, where volume is the total number of shares that are traded (bought and sold) during a given period of time. A reading below 1 indicates that investors are confident and it could be a good time to buy, since prices are likely to move higher, while a reading above 1 suggests the opposite.
- The Relative Strength Index (RSI): This aims to measure the speed and change of price movements, and moves between 0 and 100. In general, when the reading is above 70, it could be a good time to sell, while a reading below 30 suggests an opportunity to buy.
There are many other technical indicators employed by traders.
Top-down versus bottom-up technical analysis
Top-down technical analysis involves looking at stock-price movements over the long, medium and short term. In simple terms, this means looking at the ‘bigger picture’ first before investigating specifics.
A trader would first analyse share-price movements over the long term, and then over the medium term and the short term. This gives traders a much wider perspective on the market than if they simply focused on the short term.
So, for example, a long-term trend may show that the market is moving upwards overall, even though it may be moving sharply lower over a much shorter time frame. A trader can now base his buy or sell decision on a much wider set of data and trends.
Bottom-up technical analysis focuses on identifying charts, which suggest, for example, that a stock price is about to take off, creating an opportunity to buy and sell the stock quickly for a profit.
Bottom-up technical analysis is purely focused on spotting chart trends, which signify an investment opportunity, irrespective of wider considerations such as the performance of the index or the industry the stock is in.
Is technical analysis better than fundamental analysis?
Fundamental analysis tends to take a long-term approach to investing, while technical analysis focuses on short-term profits by buying and selling undervalued stocks quickly.
Many investment professionals use fundamental analysis to determine which stock to buy as a long-term investment, but also employ technical analysis to identify the best time to buy a stock.
The best approach may be to consider both types of analysis when evaluating a stock and then, over the long term, decide which form of stock analysis works best for your particular trading strategy.
» MORE: Basic investment strategies
How accurate is technical analysis?
Stock and other financial markets tend to be unpredictable, and no form of analysis – technical or fundamental – can provide a fully accurate guide to future price movements.
By studying historical price patterns, it maybe possible to forecast how a stock will behave if market conditions are similar in the future. But technical analysis is also subject to the criticism that there is no reason why previous performance should influence the future: the phrase ‘past performance is not a guide to the future’ is a common warning in investment literature.
WARNING: We cannot tell you if any form of investing is right for you. Depending on your choice of investment your capital can be at risk and you may get back less than originally paid in.
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Anthony is a BBC-trained journalist. He has worked in financial services and specialised in investments for over 20 years, writing for various wealth managers and leading news titles. Read more