What is a Technical Analysis?

Published by Thomas Herold in Economics, Investments

'Technical Analysis' is explained in detail and with examples in the Investments edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.

Technical analysis is a method for studying markets and stocks in an effort for individuals to make effective price predictions. Investors use it in their attempts to carry out better investment choices and decisions. The opposite idea of technical analysis is known as fundamental analysis.

What sets technical analysis apart from other forms of competing analysis is the fact that it takes a totally unique approach in reviewing information. Technicians, also known as chartists, are not interested in the intrinsic value of the markets, a commodity, or a stock company. Instead they are concerned with just the market’s price movements higher and lower.

In its simplest form, technical analysis only considers demand and supply. Followers of this form of analysis study this so that they can predict which way the markets or prices will move, or in which direction the trend of the underlying instrument is. They are not interested in the underlying parts of the market.

Instead they wish to understand all that is happening by analyzing the actual market itself. Technical analysts do this by studying the market or instrument’s price history and volume. They take these data points and plot them out on computer-generated charts and various other tools to seek out any recurring patterns that might indicate what the stock or market will do in the future.

Besides price up and down action, technical analysis heavily relies on volume to confirm ideas. Volume is the quantity of contracts or shares which changes hands in a certain amount of time, most commonly in a period of a day. Greater volume equates to more activity in an underlying security. Figuring the movement of the volume involves technicians studying the volume bars in a chart. These are usually located at a chart’s bottom. These volume bars demonstrate the number of shares or contracts which have changed hands in a period. This is how they display trends in the same manner as price action does.

Volume is used to prove the strength of price movement. A higher volume means that there is more commitment to the associated movement. Lower volumes convey a lack of conviction in a price movement up or down. High volumes can be used to prove a change in a trend if the evidence of a change is overwhelming otherwise.

Three basic ideas or assumptions underlie the study of technical analysis. First, the market already takes everything into account. Second, the prices move up or down in identifiable trends. Finally, the price action movement will be likely to repeat itself again.

1. The Market Already Takes Everything Into Account

Technical analysts have been criticized for only looking at price movement and volume, but they believe that all known information is already fully and fairly priced into a market or stock price. This includes fundamentals of a company, overall economic factors, psychology of investors, and even unknown event risks. According to their point of view this eliminates the point of separately considering the company’s fundamentals and other factors since they believe all of this to be already fairly priced into the underlying stock. In their minds it is only price movement based on supply and demand that they need to consider.

2. Prices Move Up or Down In Identifiable Trends

Technicians also hold with the idea that prices moving up or down are following trends, or movements in one general direction. They believe that after the market has set out a direction, the price movements in the future will tend to follow in that direction rather than to move contrary to it. The majority of strategies for technical trading go along with this premise.

3. Price Action Movement Will Likely Repeat

Technical analysis considers this idea of price action and movement repeating to be very important. Followers of this analysis believe that market psychology accounts for this repetition, as investors in the market will usually react in a similar fashion to market influences over time. Chartists utilize patters in the charts to study these movements and grasp the accompanying trends. Technicians have used a great number of these different charts for in excess of a hundred years precisely because they show price action patterns that continue to repeat themselves again and again.

It is important to remember that technical analysts do not only use this form of price prediction for stocks. In fact they can employ it on any instrument that has a body of historical trading information. This means that technical analysis works on stocks, commodities, futures, Forex foreign exchange, fixed income investments, and other financial instruments.

Though many technicians use and consider technical analysis to be effective for predicting the prices of stocks, it is most commonly applied to Forex and commodities trading. This is because most investors in these two markets are short term traders.

Free Download (No Signup Required) - The 100 Most Important Financial Terms You Should Know!
This practical financial dictionary helps you understand and comprehend the 100 most important financial terms.

The term 'Technical Analysis' is included in the Investments edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.