Short-term traders and long-term investors use technical analysis to help them determine potential entry and exit signals for their investments.
Investors use a variety of methods to identify and evaluate investing opportunities. Two of the most common are technical analysis and fundamental analysis. Let’s start by defining both:
Fundamental analysis usually means searching and analyzing a company’s financial statements. Investors may scour balance sheets and income statements, looking for signs of value or potential growth. Fundamental analysts tend to assume that stock markets are random and therefore difficult to predict.
Technical analysis is the study of historical price and volume on trading charts to identify and project price trends. These price trends are then used to identify potentially profitable investment entry and exit points.
Technical analysts—also known as technicians—are more interested in charts than fundamentals; the stock (or price) chart is a technician’s primary tool for decision making. They use charts to identify outperforming stocks, then invest in those stocks.
By plotting price over time, trading charts allow technicians to identify trends in price movement—the prevailing direction of price. Generally, a trend doesn’t appear as a straight line. Instead, it moves in waves, making a series of peaks and troughs or highs and lows. There are three main types of trends: up, down, and sideways (see figure 1).
An uptrend is a sequence of higher highs and higher lows. A downtrend is the same as an uptrend, but in reverse. Each lower high leads to a lower low. Then, each lower low is followed by a new lower high. As long as this continues, the price is in a downtrend.
Traders who believe a stock will continue to fall are considered “bearish." They may still attempt to profit from a downtrend by shorting, which means borrowing stock from their brokerage firm and selling it with the hope that they can buy it back at a lower price. It’s selling high, then buying low. As with long positions, the profit is the difference. However, in addition to commissions, the brokerage firm charges interest, or margin, to borrow the stock. If the stock rises instead of continuing to fall, traders with a short position may have to buy the stock back at a higher price. That means they lose money, including commissions and margin interest.
Finally, a sideways trend is a sequence of roughly equal highs and equal lows. During a sideways trend, price tends to stay in a horizontal channel. When a stock’s price moves between highs and lows, technicians may say that it’s consolidating. There are also times when a stock moves sideways but without marking any clear highs and lows. This signifies an absence of trend.
When placing a trade, technical analysts first consider the trend, because they believe trading with the trend increases the probability of success. An uptrending stock is considered more likely to keep uptrending, while a downtrending stock is likely to keep downtrending. It’s the physics of investing—an object in motion tends to stay in motion. A basic assumption of technical analysis is that the price of the stock reflects the market’s collective knowledge. So unless something happens to change the overall sentiment of the stock market, price will likely continue to move in the same direction.
But remember, using technical analysis as a proxy for the wisdom of the crowd can be risky. Some view technical analysis as having an element of “self-fulfilling prophecy," especially during times of general market stability, or when there is a dearth of fundamental data affecting a stock. Even when using trading charts to assess stock prices, you might want to keep an eye on the fundamentals as well.