Technical analysis is the study of past market action to try to gauge what the market might do in the future. At its most basic, it is the study of price. Fundamental analysis involves analyzing the characteristics of a company in order to estimate its value. Technical analysis takes an entirely different approach; it doesn’t care about the “value” of a company. Technical analysis is only interested in the price movements in the market.
Technical analysis philosophy: 3 basic tenets
Market action discounts everything
- All known information related to the security is reflected in the price of the stock; this includes fundamental factors
- As soon as new information comes to light it’s immediately reflected in the stock’s price
Prices move in trends
- In technical analysis, prices of securities tend to move in observable trends with a tendency to stay in the trend
- The trend is considered to be intact until the trend line is broken
- After a trend has been established, the future price movement is more likely to go in the same direction as the trend rather than against it
- The old adage “the trend is your friend” means you should trade in the same direction as the trend
History repeats itself
- Technical analysis is the study of what has happened to the price of a security in the past with the expectation that history tends to repeat itself
- Many of the chart patterns in technical analysis have been used for more than 100 years, and they are still believed to be relevant because they illustrate patterns in price movements that often repeat themselves
- The repetitive nature of price movements is attributed to market psychology
When you take away all the bells and whistles, technical analysis is basically a study of supply and demand. If you understand the benefits and limitations of technical analysis, it can give you a new set of tools or skills that will help enable you to be a better trader or investor. Keep in mind that technical analysis is performed by humans; it’s not an exact science and, as such, is not perfect.