What is Technical Analysis?

Navigating the financial market requires more than instinct—tools are essential to help make sense of price movements and trends. Investors often turn to two such approaches: fundamental analysis and technical analysis. While fundamental analysis helps determine the overall financial health and valuation of a company, technical analysis examines price and volume data to try to anticipate future price movements of stocks or other instruments.

This article focuses on technical analysis, a tool that is important for short-term traders but can also help long-term investors identify entry or exit points in the market.

• Table of contents

• What is technical analysis?
• Understanding technical analysis
• Use of technical analysis
• Technical analysis and stock market charts
• Understanding trend lines
• Indicators of technical analysis
• Advantages and limitations of technical analysis

What is technical analysis?

Technical analysis is the method of evaluating stocks based on statistical analysis of historical price and volume data. It is used to analyse past trends and identify potential future movements. Technical analysis operates under the assumption that stock prices reflect all known information, and market trends repeat periodically.

While technical analysis is commonly applied to stocks, this approach is also used for evaluating movements of commodities, derivatives, etc.

Understanding technical analysis

Technical analysis is based on the idea that everything known about a stock—like company news, earnings, and market sentiment—is reflected in its price. It also assumes that prices move in trends, and these trends tend to repeat over time. Active traders use technical analysis to find these patterns and trends in prices. They believe recurring price patterns reflect investor reactions, which they use to inform their trading decisions.

Also Read: What is an IPO?

Use of technical analysis

Technical analysis has a variety of applications:

• Short-term trading: Intraday and swing traders use it to identify short-term trends and make trading decisions accordingly.
• Entry/exit timing: Technical analysis helps investors identify potential timeframes (or price levels) to buy or sell stocks.
• Risk management: Technical analysis is often used to set stop-loss and profit target levels based on chart patterns. These levels can help define potential exit points, though market movements may not always align with expectations.
• Supplementing other analysis: Technical analysis is used alongside fundamental analysis to time entries and exits more strategically.
• Cross-market applications: Apart from stocks, technical analysis is also heavily used in cryptocurrency, commodities, derivatives, and other markets.

Technical analysis and stock market charts

To apply technical analysis, investors often rely on visual tools that make market trends easier to interpret. Among these, price charts play an important role by offering a snapshot of how a stock has behaved over time. Here are some primary chart types:

• Line charts: These charts simplify price actions by plotting the closing prices of a stock over a period.
• Bar charts: These inform traders about price ranges and momentum by displaying open, high, low, and close (OHLC) prices.
• Candlestick charts: These depict price movements with coloured candle-like structures, reflecting bullish or bearish activity.

Once price movements are plotted on a chart, many traders draw trend lines to identify direction.

Understanding trend lines

Trend lines are used to connect price points on a chart to identify the direction of price movements. They can be upward (bullish), downward (bearish), or sideways (ranging). Key components include:

• Slope: A positive slope indicates an uptrend, while a negative slope shows a downtrend.
• Touchpoints: The more times a price touches the trend line without breaking it, the more significant that trend line is considered.
• Duration: Trend lines that hold over longer periods are considered relatively more reliable.
• Breakouts: If the price breaks through a trend line, it could suggest a shift in momentum, but such signals must be interpreted cautiously and in context.

Indicators of technical analysis

Technical indicators add another layer of insight when it comes to analysing price movements. They can be broadly classified into the following four categories:

• Momentum indicators measure the speed of price movements and identify overbought/oversold conditions. Examples include RSI (Relative Strength Index) and Money Flow Index (MFI).
• Trend indicators identify the direction and strength of trends. Examples include Moving Averages and Average Directional Index (ADX).
• Volatility indicators like Bollinger Bands measure price fluctuations and identify possible breakout opportunities.
• Volume indicators such as OBV (On Balance Volume) help track buying and selling pressures.

Also Read: Stock Market Trading: Meaning, Types, and Historical Context

Advantages and limitations of technical analysis

Advantages

• Decision-making: Charts offer visual clarity and help eliminate biases in trading decisions.
• Visualisation: Charts help adapt data into digestible formats that distinctly highlight patterns.
• Versatility: These can be used across instruments like crypto, forex, commodities, stocks, etc.
• Pattern recognition: Many indicators and chart patterns are used to try and identify potential reversals and price movements.

Limitations

• Subjectivity: There is variation in how analysts interpret charts, which may lead to conflicting viewpoints and strategies.
• False signals: Indicators can sometimes mislead traders, especially in volatile markets.
• Not all-encompassing: Technical analysis ignores macroeconomic shifts or earnings surprises, which can result in missed context.
• Not foolproof: Despite the patterns and tools used, technical analysis cannot guarantee future outcomes. Markets are influenced by countless unpredictable factors, making any forecast inherently uncertain.

Conclusion

Technical analysis can be helpful when used with other forms of analysis (like fundamental and market sentiment analysis). While it isn’t foolproof, it can help identify patterns that can inform investment or trading strategies. A thoughtful application of technical analysis can help traders refine their approach, but it does not guarantee returns.

FAQs:

What is technical analysis, and how does it work?

Technical analysis is used to forecast price movements of securities by the statistical analysis of historical price and volume data. However, it does not assure accurate predictions.

How to do a technical analysis of stocks?

Begin by studying price charts, then identify trends using trend lines, apply indicators like RSI or MACD, and look for patterns to enter and exit trades. Always combine this with appropriate risk management.

What is fundamental analysis and technical analysis?

Fundamental analysis is the study of financial data like revenue, profits, etc. to ascertain a company’s overall financial position. Technical analysis is the study of price and volume trends to try and predict future market movements.

What are the two types of technical analysis?

Two types are chart pattern analysis and technical indicators (i.e., moving averages, RSI, etc.) They are often used together for a more comprehensive view.

What are the technical analysis methods?

These methods include trend analysis, chart patterns, volume analysis, candlestick analysis, and the use of technical indicators such as MACD, Bollinger Bands, RSI etc.