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. To better understand technical analysis, it’s a good idea to define both. This way you know what it is and what it’s not.
Technical analysis is the study of historic price and volume to identify and project price trends. These price trends are then used to determine potential profitable investment entry and exit points. Technical analysis is a type of financial analysis performed through charts and is the focus of the Investools Technical Analysis course.
Fundamental analysis is commonly characterized by searching and analyzing a company’s financial statements and scouring balance sheets and income statements—all the while looking for signs of value or potential growth. Fundamental analysts tend to assume that markets are random and therefore difficult to predict. You can learn more about this discipline in the Investools Fundamental Analysis course.
Technical analysts—also known as technicians—are more interested in charts than fundamentals. These investors use charts to identify outperforming stocks, then invest in those stocks. In fact, the stock, or price, chart is the primary tool for decision making.
A chart is a function of price and time, meaning it charts the price of a security over time. The chart below is a two-year daily chart, which means it tracks the stock’s daily price fluctuations over a two-year time frame.
FIGURE 2: A CHART GRAPHS THE MOVEMENT OF PRICE OVER TIME.
The price is commonly on the left and the dates are on the bottom. Image courtesy of the Investools® Technical Analysis course. For illustrative purposes only.
By plotting price over time, charts allow technicians to identify trends, or a prevailing direction of price movement. Generally, a trend isn’t a straight line. Instead it moves in waves, as a series of peaks and troughs or highs and lows. There are three main types of trends: up, down and sideways.
An uptrend is a sequence of higher highs and higher lows.
FIGURE 4: STOCKS DON’T OFTEN FALL IN A STRAIGHT LINE EITHER.
Stocks commonly fall at a faster rate than they climb, but they’ll still experience intermittent rallies. Image courtesy of the Investools® Technical Analysis course. For illustrative purposes only.
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 bearish. These traders can still potentially profit from a downtrending stock through shorting—or 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 would have to buy the stock back at a higher price. They’d lose money, including commissions and margin interest.
Finally, a sideways trend is a sequence of roughly equal highs and equal lows.
FIGURE 5: EVEN GOING SIDEWAYS, A STOCK DOESN’T COMMONLY MOVE IN A STRAIGHT LINE.
Sideways trends can be the launching point for a directional trend or a pause in a longer-term trend. Image courtesy of the Investools® Technical Analysis course. For illustrative purposes only.
During a sideways trend, price tends to stay in a horizontal channel. When price moves between highs and lows like this, technicians say that it’s consolidating—it’s not breaking out of the barriers on either side. There are also times when a stock moves sideways but no clear highs and lows exist—this signifies an absence of trend.
When placing a trade, technical analysts first consider the trend. This is because technical analysts believe trading with the trend increases the probability of success. An uptrending stock is more likely to keep uptrending, while a downtrending stock is likely to keep downtrending. It’s the physics of investing. An object in motion stays 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.
Stay tuned! Next week we will take a closer look at the use of support and resistance to identify areas of supply and demand.
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