What is Technical Analysis in Investing?

What It's About

Technical analysis is one of two major ways for investors to understand how stocks will move over time.

Technical analysis (sometimes abbreviated TA) is one of two major ways for investors to understand how stocks will move over time. Technical analysis starts with the assumption that a stock’s future price can be predicted based on how it’s traded in the past. From there, technical analysts, or “technicians” or “chartists” examine the stock’s chart using a variety of techniques and tools in order to predict how the stock will perform in the future, especially over the short term.

Technical analysis is more popular with traders who are in the markets for the short term and are not interested in being long-term owners of the company, as many investors are.

The second major way to understand price movements is called fundamental analysis (sometimes called FA), a method that relies on analyzing the underlying company’s performance (sales growth, profit margins, and finances, among others) in order to forecast where it will move in the future.

What does technical analysis actually analyze?

The fundamental premise of technical analysis is that investors can gain insights into where a stock price will move based on where it’s been. So technicians examine charts of past price movements looking for repeating patterns or trends that might allow them to predict stock prices. The number of tools and styles available for technical analysis feels almost limitless, and many traders use multiple systems to help identify opportunities. Here are some of the most popular tools of technical analysis.

Moving average convergence divergence (MACD)

MACD is a tool that follows the momentum of a stock, using the stock’s moving average prices to indicate where it may trade in the future. The MACD uses two basic moving averages, the 26-day exponential moving average and the 12-day exponential moving average. Technicians subtract the 26-day average from the 12-day to create the MACD line. From there, traders create a 9-day exponential moving average for the MACD line, and this line acts as a signal for when to buy and sell.

To time their trades, technicians watch for when the MACD lines crosses the 9-day average line. When the MACD line moves up and crosses above the 9-day line, it’s an uptrend and signals traders to buy the stock. When the MACD line falls and crosses below the 9-day line, it’s a downtrend and traders are supposed to sell.

That’s MACD in a nutshell, though there are more complex parts of the approach and many other variations on this basic theme.

Fibonacci techniques

You might remember the Fibonacci sequence from junior high school, but many traders use the technique to predict where stock prices have support and resistance. (Support keeps the stock from moving lower, while resistance keeps the stock from moving higher.) One of the more popular techniques is called Fibonacci retracement, and here’s how it works.

This form of technical analysis first identifies the high and low on a stock chart. Then the trader draws five horizontal lines on the chart at price points that correspond to percentages that are important in Fibonacci numbers: 100% (the stock’s high point), 61.8%, 50%, 38.2%, and 0%. Traders say these lines act as places of support and resistance, so as the stock nears the lines it may have difficulty breaking through them.

There are other similar techniques, including Fibonacci arcs, Fibonacci fans, and Fibonacci time zones. Each uses the Fibonacci patterns to predict where stocks may trade in the future, and many traders use multiple approaches to help determine how they should trade.

Moving averages

This technique uses moving averages to predict future price movements. One of the most popular kinds of tools here is the exponential moving average, especially the 50-day average and the 200-day average.

These averages show the short-term trend and the long-term trend, respectively, and help traders identify when a trend is breaking down and may reverse itself. The slope of the moving averages also gives traders a clue as to the strength of the trend, with steeply sloped lines indicating stronger momentum.

Typically traders are watching for when the moving averages cross one another. For example, if the 50-day average crosses below the 200-day, it could signal the short-term momentum is breaking down and the stock may be due for a fall. On the other hand, if the 50-day average crosses above the 200-day, it signals that momentum is on the upswing and the stock may begin to move higher.

Traders also watch for when the stock itself crosses one of these moving averages, especially a longer-term moving average. A stock moving above a long-term trend is a bullish signal, while a fall below the average indicates that the stock may be ready to move even lower.

Chart patterns

This is another favorite for technical analysts, and traders use bar charts of stock prices to identify established trading patterns. Three of the most popular are the head and shoulders, the cup and handle, and the double top (or double bottom).

The head and shoulders pattern consists of three nearby peaks on the stock chart, with the middle peak being the highest and the other two forming what appear to be shoulders at lower stock prices. Traders watch for this pattern to identify a support level, which if breached, will signal a falling stock.

The cup and handle is a pattern that looks like the bowl and handle of a coffee cup. The pattern shows the stock first falling and then rising to a form a rounded “bowl” shape. Then the stock price pulls back a little bit over the next trading days to form the handle, setting the stock up for an even higher move. Traders try to identify the cup and handle formation as it’s creating the handle so that they can participate in the potential move higher in the coming weeks.

The double top pattern consists of a stock trying to break above a resistance line, pushing on this line twice over a relatively short period. However, it can’t seem to push past that price level. The pattern signals the end of the upward trend, and the stock is supposed to move lower. The same pattern exists for a stock in a downtrend, and it’s called the double bottom. When the stock twice fails to break through a support level, it may begin to rise higher and start a new round of upward momentum.  

Candlestick patterns

Candlestick patterns are another form of chart pattern, and a whole range of patterns exist for traders to identify. Candlesticks charts are a type of bar chart that shows the stock’s price movement, opening and closing prices, highs and lows, and trading range. Each day’s information is recorded in a single figure that looks like a candlestick, and has little tails at the top and bottom that are called wicks to convey the stock’s high and low of the day.

Candlestick charts provide more information than bar charts or line charts by capturing the open, close, high, and low price for each day.

Traders use candlesticks as another technical analysis tool and they attempt to identify a variety of patterns that indicate traders’ sentiment for the stock. The patterns are divided into two broad categories — continuation patterns and reversal patterns. Continuation patterns suggest the prevailing trend will continue, while reversals indicate that a trend will change direction in the near term.

Does technical analysis work?

Some technicians swear by their charts, while other investors say they’re nonsense. But technical analysis does have an element of truth in it, even if it’s only a self-fulfilling prophecy. Stock prices are based on expectations, and when expectations changes, prices will change. So if enough people believe that a stock will rise or fall based on a chart or some other prediction, then it will move. Even small price moves can kick off the momentum that starts an uptrend or downtrend. Then investor psychology kicks in and momentum investors join the party, and the stock moves higher or lower.

So technical analysis can work, but it’s by no means a foolproof system for prediction. Rather than just plunging in when a signal says to buy or sell, many traders watch carefully to see if the stock moves as imagined. If so, they hop on the trend, propelling the stock further.

Who uses technical analysis?

Technical analysis is more popular with traders who are in the markets for the short term and are not interested in being long-term owners of the company, as many investors are. Instead, traders are looking to profit off short-term moves (sometimes even just seconds) in the stock price, and they need a system that identifies patterns or tendencies in the market.

Schism between technical analysis and fundamental analysis

While technical analysis is more often the tool of traders, fundamental analysis is more often the tool of investors, those who tend to stay invested for long periods or those who “buy and hold.” These two schools of thought are often at odds over what moves stock prices, with technical analysts often criticizing fundamental analysts of being blind to what the charts are saying and fundamental analysts saying that technicians are using witchcraft.

Here’s how some investors use fundamental analysis to predict stock prices.

By Connor Round
Wealthbase Contributor

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