What’s technical analysis and how does it differ from fundamental analysis? What traders should use it for a trader’s edge? If you want to start using technical analysis, where do you begin?
This article discusses the many ins and outs of technical analysis. No matter where you are in your investing journey it helps to gain a deeper understanding of this trading method that has been around since the late 1800s. Continue reading to learn more about technical analysis.
What Is Technical Analysis?
Technical analysis is a trading strategy that uses trend analysis to predict and identify trading opportunities by analyzing statistical trends from trading activity, such as price movement and volume.
A few things to remember when learning about technical analysis:
- Technical analysts believe past trading activity and price change are indicators of future price movements.
- Price trends and patterns are the backbones of technical analysis as a trading discipline.
- You can contrast technical analysis with fundamental analysis, which focuses on a company’s financials rather than historical price patterns or stock trends.
Understanding Technical Analysis
Fundamental analysis evaluates securities value based on business results such as sales and earnings. Technical analysts focus on price and volume. Traders who use this strategy incorporate tools that evaluate changes such as price, volume, and implied volatility.
More often than not, traders use technical analysis to generate short-term trading signals from various trading tools. Traders can apply these tools to any security with historical trading data, including stocks, futures, commodities, fixed-income, currencies, and other securities. While technical analysis applies to all securities, traders primarily use it in commodities and forex markets, where traders focus on short-term price movements.
A Brief History of Technical Analysis
The first examples of technical analysis stem from Charles Dow in the late 1800s within the Dow theory. Several noteworthy researchers, including William P. Hamilton, Robert Rhea, Edson Gould, and John Magee further contributed to Dow Theory concepts to form its basis.
Modern-day technical analysis includes hundreds of patterns and signals developed over the years since these researchers began exploring technical indicators. Technical analysis’s focal point comes from the assumption that past trading indicators influence future performance. When paired with rational trading, these technical indicators can be valuable for traders of all kinds.
Professional analysts don’t often use technical analysis in conjunction with other forms of research. Retail traders might make decisions solely based on price charts and similar statistics, but practicing equity analysts are not as cavalier with their investment strategies.
Technical Analysis Strategies for Beginners
Top-Down
The top-down approach to technical analysis trading is a macroeconomic analysis that examines the whole economy before focusing on individual securities. Traders using a top-down approach focus on the economy, then sectors, and finally individual securities. Top-down traders focus on short-term strategies instead of long-term.
Bottom-Up
Bottom-up technical analysis strategies focus on individual stocks instead of a macroeconomic view. Traders utilizing a bottom-up approach look for individual stocks with intriguing entry and exit points. For example, a trader who finds what they believe to be an undervalued stock in a downtrend might use technical analysis to identify optimal entry and exit points. Traders employing this method hold long-term views on their trades.
Other strategies for technical analysis include day traders using trendlines and volume indicators to make their decisions. On the other hand, Swing traders use chart patterns and technical indicators and algorithmic traders might develop different requirements that combine volume and technical indicators.
Technical Analysis Vs. Fundamental Analysis
Technical analysis and fundamental analyses are pretty much night and day. Technical indicators use price action to predict future security movements. At the same time, fundamental analysis involves evaluating a particular company’s stock to determine its overall value based on factors that may affect the price in the future.
While fundamental analysis uses financial data, industry trends, competitor performance, and economic outlook, technical relies heavily on price action and market psychology. Both of these methods require extensive planning, and there is no guarantee with either.
Choosing between the two comes down to your trading style. If you’re a calm, collected trader, choosing a long-term investment strategy such as the ones that form fundamental analysis strategies will likely be the most beneficial strategy for you.
If you’re looking for more of a short-term strategy, such as those day traders use, you should consider technical analysis.
Pick a Strategy or Develop a Trading System
The first step to creating a technical analysis strategy is to pick a system that suits your needs. Technical analysis might not be for you, and that’s okay- different strokes for different traders. You shouldn’t force a strategy that doesn’t align with your personality. However, if you’re looking for short-term growth, technical analysis can be a valuable strategy for you to employ.
Identify Securities
Technical analysis is as much about rooting out the securities that don’t align with your strategy as it is about finding the ones that do. Technical analysis best suits liquid and volatile securities instead of stable stocks because of the objective behind the plan: short-term growth.
Different stocks or contracts might also require other parameter choices. In this case, different moving averages such as 15-day and 50-day moving averages can.
Find the Right Brokerage
Finding a suitable brokerage for you means they support your security types and have the required tracking and monitoring tools in place. Additionally, they’ll keep costs low and help you avoid eating into profits.
Track Your Trades and Use Software or Tools
Different traders require different metrics and software to measure their success and strategize for future trades. For example, day traders require margin accounts that give the trader access to Level II quotes and market maker visibility.
Conclusion- What Is Technical Analysis?
Technical analysis is an excellent trading tool for day traders or any other trader looking to implement short-term gains. This type of analysis differs from fundamental analysis, which incorporates economic analysis instead of price action analysis.
When it comes to asking whether one or the other is right for you, the question should be more about which one is more lucrative and which is more feasible for you. Are your trading habits geared more toward long-term investments, or are you looking for short-term profits? The answer to that question should help you decide more than any promises for profits.