What is Technical Analysis?

There are two main ways to analyze stocks: fundamental and technical analysis. While fundamental analysis focuses on a company’s financial health through metrics such as revenue, earnings and debt, technical analysis examines a stock’s recent and historical activity to identify buy and sell signals based on chart patterns. 

In this guide, we’ll explore the basics of technical analysis and whether it may be a good fit with your overall investing strategy. 

What is Technical Analysis? 

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 the 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.

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: It 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: Support and resistance 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 will retrace to after a pullback before it continues its original trend. It is 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 is an upward price trend and when it is below zero, there is 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.

Because technical analysis doesn’t take these factors into account, 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.

Benzinga’s Take

For novice investors, technical analysis can be effective when used with appropriate risk management strategies. However, no trading system is 100% perfect, and it’s certainly not a path to getting rich quickly in the market.

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