What is a technical analysis of stocks? It may surprise you to learn that technical analysis is a polarising term. If you were to ask a trading nerd about it, they would probably tell you that it’s an end-all-be-all methodology that can accurately predict the future of the market. But if you spoke to a seasoned value investor, they might liken it more to a tea-leaf reading than an exact science.
Where does the truth lie? As always, somewhere in the middle.
If you look at the price of an asset day in and day out, after a while you may notice that there are certain trends and patterns that repeat over time. They may not replicate exactly, but they’re similar enough. The price rises when investors think a stock is undervalued and they buy it en-mass. At a certain point investors decide the stock is overvalued, they sell it, the price goes down and the cycle continues. A fine balance of supply and demand.
If you believe that at any given moment the chart reflects the mood of market participants more than it does the fundamental factors, you may conclude that technical analysis is a study of mass psychology by means of reading stock charts.
And you’d be right. The goal of technical analysis is to take raw market data and process it to predict a possible trend change before the supply/demand pendulum swings, so to say.
As with any prediction, technical analysis can’t be accurate 100% of the time. Still, when performed correctly, it can point to the most likely course based on the current conditions.
Key Concepts of Technical Analysis
Perhaps, we got a little ahead of ourselves with all the jargon? In that case, let’s take a step back and go over the basics, so you have a better grasp on the technical analysis of the stock market.
Arguably the most important factor for technical analysts is the price of the security. It’s the primary measure to be considered.
Technical analysis evangelists believe that at any given time a stock’s price reflects everything that has or could affect the company. According to them, the company’s fundamentals, as well as the broader economic climate, are already priced into the stock, so there is no need to actually consider these factors separately.
Price movements, being a product of supply and demand, are therefore believed to have a cyclical nature and follow trends.
“Price is the king but volume is the key” — the saying goes. Volume is the parameter that provides information of how many shares changed hands and at what price over a given period of time. It serves as the perfect indicator of interest in the stock.
Monitoring volume is hugely important for stock price movement analysis. When used in conjunction with price analysis it serves 3 main purposes: confirming trends, identifying potential trend reversals, and confirming price breakouts (more on that later).
For a technical analyst, the trend is a White Whale. To spot one is to catch a glimpse into a stock’s future performance. The underlying belief is that mass psychology doesn’t really change over time and trading patterns from the past can indicate how security may behave in the future.
Without getting into too much detail, trends represent the general direction of a stock’s price, including all the minor highs and lows in-between. Trends can have varying durations. There are short-term, intermediate-term and long-term trends. Keep in mind, though, that a stock can experience a short-term trend within a long-term trend ( sort of like a nesting doll), so it’s important to mind the time frame when you’re discussing trends.
Support and Resistance
Technical analysis of stock trends also involves examining the stock’s “support” and “resistance” price levels. Those are the asset’s previous lows (support) and highs (resistance) that are above or below the stock’s current price.
When analysts talk about a support level, they mean there’s a certain price the stock most likely won’t dip below as there’s a demand for it high enough to prevent it. Resistance represents the price-point the market is not prepared to pay for the stock.
If a stock’s price does in fact dip below its support level, that’s bad news — a sell-off might be coming. Now, if the opposite happens and a stock breaks above its resistance level, that typically means the demand for it is rising.
Either way, once a “breakout” happens, that new price point the stock is traded at becomes either the new support or the new resistance level. Stock prices tend to bounce in-between support and resistance, making those quite useful for the purposes of predicting trend reversals.
Chart Patterns and Indicators
Now that we’ve defined the key terms and discussed the cyclical nature of price movements, let’s take a look at the two major instruments of technical analysis: chart patterns and technical indicators.
A chart pattern is a distinct formation on a stock chart that serves as a sign of an upcoming price movement. Experienced chart analysts know dozens of those patterns and use them to either confirm current trends or predict trend reversals and thereby know when to buy or sell.
There are no chart patterns to look for in stocks that can tell you exactly where the price is headed ultimately. The best they can do is warn you about the short-term prospects.
Indicators are calculations based on the price and volume of a security that graphically demonstrates trends, volatility and momentum. Indicators are often imposed over the price chart and it’s almost symbolic as they serve as an additional layer of information on security. Technical Indicators for the stock market are frequently used in conjunction with chart patterns as a means to verify the signals they give.
There are two main types of indicators: leading and lagging. A leading indicator precedes price movements, sort of like a premonition. A lagging indicator, as you may have already guessed, is a source of confirmation that the trend persists.
How to benefit from stock technical analysis
Even though technical analysis is primarily used for short-term analysis (which explains its popularity among stock traders), there are still aspects of it that can be of value to stock investors.
First of all, examining the historical pricing through a chart paints a clear picture of how the market perceived the stock in the past. If you combine these insights with some fundamentals, you have a better chance at determining if this investment has any prospects for further gains or whether the stock is already past its prime.
Secondly, fundamental analysis can only get you as far as identifying with stocks are good candidates for your money. It won’t tell you the right moment to buy it, will it? That’s where stock tech analysis comes in.
For example, companies that have high growth rates often experience large corrections. In such instances, technical analysis can be used to identify oversold levels, which make for the best possible times to go in on high-growth stocks. Only then can you open up Orca’s share trading app UK, and click “Buy” with confidence.
Limitations of technical analysis of stock market
Along with all the benefits, technical analysis actually carries some significant limitations. The first of which is the fact that it only works on assets where the price is governed by the law of supply and demand and doesn’t work for securities where prices are regulated otherwise (say, by political decrees).
On top of that there are 3 conditions that have to be met in order for technical analysis to work properly for a stock:
High liquidity. The security has to be traded in sufficient volumes. Low-liquidity stocks are easier to manipulate, rendering the analysis unreliable.
No artificial pricing. If a company was to split their stock, that would be considered an artificial price change, since the intrinsic value of the company hasn’t changed. Events like that can’t be adequately assessed by technical analysis.
No extreme news. Technical analysis can not account for force majeure events like a natural disaster, a terrorist attack or the death of a CEO.
But even if the stock does fit all the right conditions, the results of technical analysis can be mixed. Different indicators, even when applied to the same chart, can give contradicting signals. Chart patterns are largely subject to interpretation. That’s why technical analysis is virtually never used solo.
As you can see, technical analysis is no crystal ball and there’s no magic involved. It won’t tell you what stock to pick or how to get free shares, but under the right conditions, it will help you identify just the right moment to buy or sell.
- Technical analysis studies supply and demand in a market in an attempt to determine what direction the price of an asset will continue in the future.
- Performing technical analysis on stock can enhance your perception of its potential for growth, as well as help you identify the best time to buy or sell it.
- Technical analysis is not an exact science and can generate mixed signals. It’s, therefore, best used in conjunction with fundamental analysis.