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Technical Analysis: Definition and How to Use It in Investing

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Technical Analysis: Definition and How to Use It in Investing

One of the crucial tools that have been adopted in the financial market for the purpose of making informed and adequate financial decisions is ‘technical analysis’.

Since its inception, the concept of technical analysis has been welcomed by traders, analysts, and investors due to its behavioral financial aspects. With the use of predefined tools, technical analysis enables users to carefully examine the way in which the supply and demand for a particular security might influence changes in price, volume, and implied volatility.

While technical analysis has proven to be a reliable standard for evaluating market trends and behaviors, it has achieved broad acceptance among regulators and the academic community all over the globe.

In this guide, we will unpack all that there is to know about technical analysis including its indicators, key principles, and lots more.

Technical Analysis Explained

Technical analysis is a method used by investors and traders to evaluate investment opportunities based on historical price and volume data. It involves studying charts and patterns of past market data to predict future price movements. Traders analyze charts and patterns to identify trends, support and resistance levels, and potential reversal points.

Unlike fundamental analysis, which focuses on financial statements and company performance, technical analysis relies on market data. Its tools are used in verifying the effect of security demand and supply on price change, volume, and vitality.

Information derived from technical analysis helps analysts in the improvement of their overall value estimate. Through years of research, technical analysis has evolved to include developed patterns and signals in their hundreds.

Key Principles in Technical Analysis

Technical analysis involves hundreds of patterns and signals while forming necessary principles to critically study the price and volume of securities including stocks, futures, commodities, bonds, and currencies. Some of the key principles of technical analysis observed during the study and scrutiny of securities include the following:

  1. Price discounts everything: all relevant information is already reflected in the price.
  2. Price moves in trends: prices tend to move in trends, whether upward, downward, or sideways.
  3. History tends to repeat: chart patterns and trends often repeat over time.
  4. Support and resistance: certain price levels act as barriers that influence price movements.
  5. Volume confirmation: volume can validate the strength of a trend or signal potential reversals.

Technical Analysis Indicators

Indicators are mathematical calculations applied to price and volume data to generate trading signals. Common indicators of technical analysis include price trends, chart patterns, volume and momentum indicators, oscillators, moving averages, and support and resistance levels.

Some of these indicators are focused primarily on identifying the current trends in the market, including support and resistance areas. Meanwhile, other indicators are focused on determining the strength of a trend and the likelihood of its continuation.

Nonetheless, the indicators generally help traders to identify overbought and oversold conditions and determine the strength of trends.

Types of Technical Analysis Charts

Technical analysis is represented in the following forms:

  •  Line charts. Line charts are the simplest forms of representing technical analysis, showing closing prices over time. They are like a quick peek at data that shows how something changes over time. Hence, they help you to compare two or more securities or indexes. Line charts simply depict price action. Think of it like a line on a graph. If it goes up, it symbolizes things are getting better. If it goes down, it means that things are getting worse. And if it’s flat, nothing much is happening. Hence, since economic data doesn’t have open, high, and low data, line charts work best in analyzing economic indicators which include employment trends, or consumer prices.
  • Bar charts. Bar charts often display open, high, low, and close prices for a specific period. The chart displays vertical bars which each represent a specific time period, like a day, a week, or a month. Usually, bar charts might seem more crowded compared to simple line charts, but they give you a deeper understanding. They’re like a magnifying glass for price moves, especially over longer periods, like years. By color-coding the bars, with green for when prices went up and red for when they went down, you can quickly see the general trend. You can also figure out the price range – that’s the difference between the highest and lowest points on the bars. Plus, you can see where the starting and ending prices are relative to the highest and lowest, and how the start and end relate to each other. This helps you figure out if there was more buying or selling going on.
  • Candlestick charts. Candlestick charts are known for providing visual clues about price action and market sentiment. They share similar features with bar charts, however, the difference between them lies in the space between the starting and ending prices which is recognized as the body. Basically, candlestick charts give clues about how investors are thinking. If the ending price is higher than the starting one, this body is usually white or green. If it’s the other way around, with the ending price lower, the body turns black or red. If there’s no change, the body becomes a flat line. Now, the lines above and below this body are like the candle’s “shadow” or “wick.” They add more details. By looking at how the starting and ending prices relate to each other, you can tell if people are feeling bullish (optimistic), bearish (pessimistic), or unsure. A long green or white candlestick means folks are feeling positive. A long red or black one suggests the opposite. A short body means people are undecided.

Technical Analysis vs Fundamental Analysis

Fundamental analysis and technical analysis are both used for researching and forecasting future trends in stock prices, and both have their advocates and adversaries.

Fundamental analysis is a method used for evaluating securities by attempting to measure the intrinsic value of a stock. Fundamental analysts study everything from the overall economy and industry conditions to the financial condition and management of companies. Earnings, expenses, assets, and liabilities are all important characteristics to fundamental analysts.

In Technical analysis, the difference is that the stock’s price and volume are the only inputs. The core assumption is that all known fundamentals are factored into price, hence no need to pay close attention to them. Technical analysts do not attempt to measure a security’s intrinsic value, but instead, use stock charts to identify patterns and trends that suggest what a stock will do in the future.

Why Use Technical Analysis?

It is important to note that the need for technical analysis in the financial market cannot be overemphasized. Technical analysis has been performing as a valuable tool for traders as it helps predict price movements, decide entry and exit points, and assess asset values.

Moreso, it is particularly useful when fundamental data is lacking, like in the case of cryptocurrencies. Apparently, technical analysis offers a well-rounded approach to investing when paired with fundamental analysis. Nonetheless, some of the functions of technical analysis are highlighted below:

  • Timing entry and exit points. Technical analysis helps traders time their trades for optimal entry and exit points.
  • Risk management. By identifying support and resistance levels, traders can set stop-loss orders to manage risk.
  • Market sentiment. Chart patterns and indicators can provide insights into market sentiment.
  • Short-term trading. Technical analysis is particularly useful for short-term traders looking to profit from price fluctuations.

Bottom Line

Technical analysis is a powerful tool for traders and investors seeking to make informed decisions based on historical price and volume data. While it has its critics, many market participants find value in analyzing charts and patterns to predict future price movements.

Undoubtedly, one may not need a degree in finance to become an investor, however, there is a need to be educated about financial trends to make proper investment decisions. Technical analysis is a major tool that is capable of providing investors with the education they need to understand the behavior of market securities and predict what the future holds for them.

Technical Analysis: Definition and How to Use It in Investing

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