Technical Analysis of Stocks and Trends Definition

What Is Technical Analysis?

Technical analysis is the use of historical market data to predict future price movements. Using insights from market psychology, behavioral economics, and quantitative analysis, technical analysts aim to use past performance to predict future market behavior. The two most common forms of technical analysis are chart patterns and technical (statistical) indicators.

Key Takeaways

Technical analysis attempts to predict future price movements, providing traders with the information needed to make a profit.
Traders apply technical analysis tools to charts in order to identify entry and exit points for potential trades.
An underlying assumption of technical analysis is that the market has processed all available information and that it is reflected in the price chart.

Understanding Technical Analysis

Technical analysis is a blanket term for a variety of strategies that depend on interpretation of price action in a stock. Most technical analysis is focused on determining whether or not a current trend will continue and, if not, when it will reverse.

Some technical analysts swear by trendlines, others use candlestick formations, and yet others prefer bands and boxes created through a mathematical visualization. Most technical analysts use some combination of tools to recognize potential entry and exit points for trades. A chart formation may indicate an entry point for a short seller, for example, but the trader will look at moving averages for different time periods to confirm that a breakdown is likely.

A Brief History of Technical Analysis

The technical analysis of stocks and trends has been used for hundreds of years. In Europe, Joseph de la Vega adopted early technical analysis techniques to predict Dutch markets in the 17th century. In its modern form, however, technical analysis owes heavily to Charles Dow, William P. Hamilton, Robert Rhea, Edson Gould, and many others—including a ballroom dancer named Nicolas Darvas.

These people represented a new perspective on the market as a tide that is best measured in highs and lows on a chart rather than by the particulars of the underlying company. The diverse collection of theories from early technical analysts were brought together and formalized in 1948 with the publishing of Technical Analysis of Stock Trends by Robert D. Edwards and John Magee.

Candlestick patterns date back to Japanese merchants eager to detect trading patterns for their rice harvests. Studying these ancient patterns became popular in the 1990s in the U.S. with the advent of internet day trading. Investors analyzed historical stock charts eager to discover new patterns for use when recommending trades. Candlestick reversal patterns in particular are critically important for investors to identify, and there are several other commonly used candlestick charting patterns. The doji and the engulfing pattern are all used to predict an imminent bearish reversal.

Technical analysis uses historical market behavior to anticipate future movements. While it can often be effective, past performance is no guarantee of future results, and traders should be careful not to over-rely on any one analytical tool.

How to Use Technical Analysis

The core principle underlying technical analysis is that the market price reflects all available information that could impact a market. As a result, there's no need to look at economic, fundamental, or new developments since they're already priced into a given security. Technical analysts generally believe that prices move in trends and history tends to repeat itself when it comes to the market's overall psychology. The two major types of technical analysis are chart patterns and technical (statistical) indicators.

Chart patterns are a subjective form of technical analysis where technicians attempt to identify areas of support and resistance on a chart by looking at specific patterns. These patterns, underpinned by psychological factors, are designed to predict where prices are headed, following a breakout or breakdown from a specific price point and time. For example, an ascending triangle chart pattern is a bullish chart pattern that shows a key area of resistance. A breakout from this resistance could lead to a significant, high-volume move higher.

Technical indicators are a statistical form of technical analysis where technicians apply various mathematical formulas to prices and volumes. The most common technical indicators are moving averages, which smooth price data to help make it easier to spot trends. More complex technical indicators include the moving average convergence divergence (MACD), which looks at the interplay between several moving averages. Many trading systems are based on technical indicators since they can be quantitatively calculated.

The Difference Between Technical Analysis and Fundamental Analysis

Fundamental analysis and technical analysis are the two big factions in finance. Whereas technical analysts believe the best approach is to follow the trend as it forms through market action, fundamental analysts believe the market often overlooks value. Fundamental analysts will ignore chart trends in favor of digging through the balance sheet and the market profile of a company in search of intrinsic value not currently reflected in the price. There are many examples of successful investors using fundamental or technical analysis to guide their trading and even those who incorporate elements of both. On the whole, however, technical analysis lends itself to a faster investing pace, whereas fundamental analysis generally has a longer decision timeline and holding period by virtue of the time required for the extra due diligence.

Limitations of Technical Analysis

Technical analysis has the same limitation of any strategy based on particular trade triggers. The chart can be misinterpreted. The formation may be predicated on low volume. The periods being used for the moving averages may be too long or too short for the type of trade you are looking to make. Leaving those aside, the technical analysis of stocks and trends has a fascinating limitation unique to itself.

As more technical analysis strategies, tools, and techniques become widely adopted, these have a material impact on the price action. For example, are those three black crows forming because the priced-in information is justifying a bearish reversal or because traders universally agree that they should be followed by a bearish reversal and bring that about by taking up short positions? Although this is an interesting question, a true technical analyst doesn't actually care as long as the trading model continues to work.

What Is the Best Technical Indicator?

While there is no "best" technical analysis tool, the most popular indicators are moving averages. These lines represent the average price of an asset over several trading sessions, without the noise of daily price movements. By comparing longer-term moving averages with shorter-term ones, traders can anticipate changes in market sentiment.

How Does Technical Analysis Work?

Technical analysis is premised on the belief that most traders will behave in predictable ways, due to herd dynamics and group psychology. For example, many traders will tend to exit a position after a sharp drop in market price, or to take profits when the asset gains a certain level. Since all traders have access to the same market information, and many of them are using the same technical analysis tools, there is also an element of self-fulfillment in technical predictions.

What Does Technical Analysis Look for?

Technical analysis examines volume and price movements to predict the behavior of other traders in the market. Because these trades cause price movements, technical analysts hope to predict future price movements based on current market behavior.

The Bottom Line

Technical analysis refers to a variety of methods to forecast future price movements in an asset or security. By watching chart patterns and sentiment indicators, these traders hope to anticipate the behavior of the wider market.