Technical analysis studies the patterns in a stock’s chart to predict where the price is headed next.
It does not take into account a company’s products or services or anything else about its business. Instead, it focuses on only two factors: stock price and volume.
The foundation underlying this approach is that historical stock price behavior tends to repeat itself. By identifying a pattern in past price performance, technical traders attempt to predict future price movement.
Modern technical analysis finds its roots in Dow Theory, which was developed by Charles Dow in the late 1800s.
In essence, Dow Theory identifies a series of higher highs and higher lows in a stock chart as an uptrend. Likewise, stocks making a series of lower highs and lower lows are considered to be in a downtrend.
This idea that a trader can look at a pattern of past price performance and predict that pattern will continue is the basis of technical analysis.
Reading a Candlestick Chart
Most technical analysis starts with a price chart that plots a stock's price over time, with dates along the bottom and prices up the side.
The most popular style is the candlestick chart, where each bar, or candle, shows four prices for one period: the open, the close, the high, and the low.
A green candle means the stock closed higher than it opened, and a red one means it closed lower.
Imagine a stock opens a trading day at $40, climbs as high as $43, dips as low as $39, and closes at $42.
That day's candle would be green, with a thick body stretching from $40 to $42 and thin lines, called wicks, reaching up to $43 and down to $39.
Recognizing specific candle shapes helps investors predict if a stock could reverse direction or keep moving up or down.
Technical Analysis Indicators
Investors use technical analysis indicators to analyze price, volume and trends, with the hope of predicting future market behavior. They transform data into signals that can help make buy and sell decisions. Here are a few common types of technical indicators:
Moving average: A moving average smooths price data and helps identify the trend direction by averaging prices over a specific period. Stock prices above the moving average signal an upward trend and below slow a downward trend.
Relative strength index: This is a measure of short-term momentum that ranges from 0 to 100. Traders typically sell or short “overbought” stocks when the RSI is above 70 and buy “oversold” stocks when the RSI drops below 30.
Support and resistance levels: These levels give a sense of the movement a stock may trade in. The support line shows the price level a stock doesn’t fall beneath, while a resistance line is the price level the stock wouldn’t trade above. Stocks move within the range defined by these two lines.
Fibonacci levels: Fibonacci levels indicate where a price may retrace to after a pullback before it continues its original trend. It’s used to project where the price will go after breaking a high or low.
MACD: The moving average convergence divergence shows trend changes and momentum. Whenever the MACD is over zero, there’s an upward price trend, and when it’s below zero, there’s a bearish period.
Aroon indicator: The Aroon indicator identifies the beginning of a new trend. It focuses on time and measures the period since a stock has seen the highest and lowest prices in a given duration.
Technical Analysis vs. Fundamental Analysis
Fundamental analysis attempts to determine a stock’s intrinsic value by evaluating economic indicators, financial statements and broader industry trends.
Traders look at a company’s metrics such as earnings, revenue growth, debt levels and other key performance indicators to assess whether a stock is overvalued or undervalued.
Technical analysis doesn’t take these factors into account, so fundamental analysts often call it a pseudoscience, as though its supporters believe stock charts alone hold some sort of predictive power.
But many technical analysts would say the patterns they identify in charts aren’t directly influencing future stock prices. Instead, they show a pattern of underlying market activity that actually is directly influencing future share prices.
Many professional investors will apply a combination of fundamental and technical analysis to reach their conclusions.
Should Beginners Use Technical Analysis?
If your goal is to build wealth over decades through a 401(k) retirement or plan, you don’t need technical analysis to succeed.
Buying regularly and staying put through the market’s ups and downs has historically served long-term investors well, and chart signals add little to that plan.
Technical analysis can be useful if you want to trade actively, or if you just want to understand why a stock moved and what traders are watching.
Keep in mind that learning the basics of technical analysis may appear easy at first, but it takes time to master. And like any other investing strategy, it’s never a sure thing.
