What is ‘Technical Analysis’
Technical analysis is a trading tool employed to evaluate securities and identify trading opportunities by analyzing statistics gathered from trading activity, such as price movement and volume. Unlike fundamental analysts who attempt to evaluate a security’s intrinsic value, technical analysts focus on charts of price movement and various analytical tools to evaluate a security’s strength or weakness.
BREAKING DOWN ‘Technical Analysis’
Technical analysts believe past trading activity and price changes of a security are better indicators of the security’s likely future price movements than the intrinsic value of the security. Technical analysis was formed out of basic concepts gleaned from Dow Theory, a theory about trading market movements that came from the early writings of Charles Dow. Two basic assumptions of Dow Theory that underlie all of technical analysis are 1) market price discounts every factor that may influence a security’s price and 2) market price movements are not purely random but move in identifiable patterns and trends that repeat over time.
The Underlying Assumptions of Technical Analysis
The assumption that price discounts everything essentially means the market price of a security at any given point in time accurately reflects all available information, and therefore represents the true fair value of the security. This assumption is based on the idea the market price always reflects the sum total knowledge of all market participants.
The second basic assumption underlying technical analysis, the notion that price changes are not random, leads to the belief of technical analysts that market trends, both short term and long term, can be identified, enabling market traders to profit from investing according to the existing trend.
How Technical Analysis Is Used
Technical analysis is used to attempt to forecast the price movement of virtually any tradable instrument that is generally subject to forces of supply and demand, including stocks, bonds, futures and currency pairs. In fact, technical analysis can be viewed as simply the study of supply and demand forces as reflected in the market price movements of a security. It is most commonly applied to price changes, but some analysts may additionally track numbers other than just price, such as trading volume or open interest figures.
Over the years, numerous technical indicators have been developed by analysts in attempts to accurately forecast future price movements. Some indicators are focused primarily on identifying the current market trend, including support and resistance areas, while others are focused on determining the strength of a trend and the likelihood of its continuation. Commonly used technical indicators include trendlines, moving averages and momentum indicators such as the moving average convergence divergence (MACD) indicator.
Technical analysts apply technical indicators to charts of various timeframes. Short-term traders may use charts ranging from one-minute timeframes to hourly or four-hour timeframes, while traders analyzing longer-term price movement scrutinize daily, weekly or monthly charts.