Technical Analysis is a technique or methodology for analysing securities with the primary goal to predict future price directions based on historical chart patterns.
Technical Analysis vs Fundamental Analysis
In finance most analysts group the techniques of security analysis into two broad categories: Fundamental and Technical Analysis. Whilst fundamental analysis focuses on the fundamental aspects of the actual company including its financial statements, earnings, balance sheet as well as market and sector environment, technical analysis predominantly focuses on the price graph of the stock. Many analysts, including Wise-owl, use a combination of Technical and Fundamental analysis in order to analyse and value securities.
This article is an introduction guide to technical analysis.
What is Technical Analysis?
As described above, technical analysis is a technique to analyse financial instruments such as shares, indices, ETF’s or any other security. The ‘technical analysts’ also known as ‘chartists’ mainly analyse the historical chart of a company’s stock and, based on certain techniques, attempts to predict the future direction of the stock price also referred to as the trend.
As opposed to Fundamental Analysis, the technique solely focuses on analysing the graph or chart of the stock and disregards fundamental information such as financial statements. The analyst attempts to identify certain chart patterns or trends within the stock’s graph, or any other graph, and conclusively makes predictions as to which direction the stock is likely to move. The only data needed for the assessment is the historical price data of the chart.
Technical Analysis is Based on Various Assumptions
Technical Analysis has been widely regarded as a tool or skill set that can assist an investor or trader in making investment decisions. Understanding the benefits and limits of Technical Analysis is an important step in order to become a better investor.
Technical analysis is based on several beliefs or assumptions. Some of the most common assumptions are:
Assumption 1: Stocks move in trends
A stock trend is a general direction in which the stock price is moving. The trend can be short, medium or long-term. Generally, stocks can either be in an uptrend, down trend or sideways trend.
Uptrend: An uptrend is when the general direction of the stock price is upwards. The best way to identify an uptrend is when the stock price creates higher peaks and higher lows. An uptrend is deemed broken if the latest low falls below the preceding low.
Downtrend: A downtrend is when the general direction of the stock price is downwards. The best way to identify a downtrend is when the stock price creates lower highs and lower lows. A downtrend is deemed broken if the latest high rises above the preceding high.
Sideways Trend: A sideways trend is when the stock price creates highs and lows at consistent price levels. A sideways trend is deemed broken if the latest high moves higher than the previous highs or the latest low moves below the previous low.
Assumption 2: Past performance is likely to repeat itself
Technical analysts try to find trends and base their forecast or conclusions on historic price movements of a stock. Based on these chart patterns coupled with the general assumption that history will likely repeat itself, they make investment decisions.
Assumption 3: The market discounts everything
Technical Analysis is based on the belief that every factor that impacts the stock price has already been taken into consideration by the market and thus is reflected in the graph. An analyst who purely focuses on technical analysis believes that the historical chart of a company provides all the information required to make future predictions. In their belief analysing the financial statements is not necessary as the market has already done that and has reacted accordingly.
Methodology of Technical Analysis
Charts are the bread and butter of Technical Analysis. Charts are used to identify and analyse patterns or trends in stock prices. Charts consist of a Y axis (vertical axis) and an X axis (horizontal axis). The X axis indicates the timeline, whereas the Y axis indicates the variable by which the security is measured, such as the price for a stock or points for an index.
Support and Resistance
Support and Resistance are important indicators in monitoring the trends of stock prices. In general terms, the ‘support level’ is a price level where a stock has consistently rebounded, this have ‘provided support’. A ‘resistance level’ is a price level where a stock has consistently failed to move past. A resistance level can be compared with a ceiling that the stock tries to break through, while the support level act like a ‘floor’.
Volume refers to the number of shares traded during a particular period of time. This measure gauges the number of shares that traded hands for either a single stock, an index or an entire market. High volume provides greater liquidity, as more buyers and sellers are present. Generally speaking it is ‘easier’ to buy and sell shares if ther eis sufficient volume. It is often considered that it has greater signficance for a stock if it moves up or down in a high volume session, than its movements in a low volume session.
Oscillators is a collective term used for indicators in technical analysis. These indicators often have a set minimum and maximum level that provides analysts with information regarding the current state of the stock. When a stock hits the minimum level, it is often considered oversold and vice-a-versa. Some of the most common oscillators used are Moving Average Convergence Divergence (MACD), Price Rate of Change (ROC), Relative Strength Index (RSI) and Commodity Channel Index (CCI).
Many traders use the moving average as a tool to find the right entry point to a stock. Some of the most common types of moving averages are:
a. Simple Moving Average: This method calculates an average price of a stock in the past ‘n’ trading days. This method just calculates average prices and results in a simple average line by giving equal weighting to old and new data/prices alike. This method is best to gauge the strength of a long-term trend. The SMA can show if a stock is currently trading above, below or in line ith its average price.
b. Exponential Moving Average: This moving average method places higher weighting to the most recent data and hence can be a more accurate measure to measure short-term trend patterns.
Technical Analysis: Common Chart Patterns
Apart from a basic continuation trend – where the stock forms higher highs and higher lows – there are several chart patterns that indicate – in technical analysis – either a continuation or reversal of a trend. We have summarised some of the most common chart patterns below.
Head and Shoulders
The head and shoulders pattern usually indicates the reversal of a trend. This pattern can be seen when a stock rises to a peak (left shoulder) and drops, then rebounds and rises higher than the previous peak (head) and declines again. Finally, the stock rises again, but lower than the second peak and drops again (right shoulder). A neckline is formed by connecting the points where the stock has been rebounding. Once the head and shoulder is formed, the technical analyst believes that the stock will likely reverse its trend. The example described above, the next move will likely be downwards. A ‘Head and Shoulders’ patterns can also be seen as a reversal patterns of a downtrend.
This a bearish reversal pattern which is made of two consecutive peaks with a moderate trough in the middle. The peaks are roughly equal and the trend resembles the letter M.
This is a bullish reversal pattern which is made of two consecutive troughs with a moderate peak in the middle. The troughs are roughly equal and the trend resembles the letter W.
An ascending triangle is seen during the continuation of an uptrend. This is a bullish chart pattern and can be recognized with the help of two trend lines. One trend line connects a series of higher lows and another trend line that connects the highs and has proven to be a strong resistance level. This shows that the stock is consolidating after a previous uptrend and once the stock breaks above the resistance, we will likely see a continuation of the uptrend. The move past the top trend line is often called a ‘breakout’.
This is a bearish chart pattern created by connecting a series of lower highs with a second trend line that connects a series of equal lows which has proven to be a strong support level. Once the stock breaks below the support level we will likely see the stock moving in a downtrend.
A symmetrical triangle is usually a result of consolidation and often represents market indecision. An attempt to push the stock higher through buying is met equally with attempts to pull the stock lower through selling. This action makes the stock move in the shape of a narrowing triangle forming an apex, often trading in low volumes. Technical analysts will wait until the stock breaks either to the up or downside which is called the breakout. The stock then tends to move in the same direction as the breakout.
Conclusion & Comments on Technical Analysis
Technical analysis is a useful tool that can complement your fundamental research and can assist investors and traders alike in making investment decisions. However, you need to be aware of the possibilities as well as limitations of technical analysis. At Wise-owl we use Technical analysis only as a supporting method as it helps us to backup our fundamental research or to determine entry or exit points.
As the markt is aware of the most common chart patterns we will often witness the so called ‘self-fulfilling’ chart patterns. This means that e.g. a breakout occurs as the entire market anticipates the next move and acts accordingly.