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The two primary approaches traders use in analyzing a stock are fundamental analysis and technical analysis. Fundamental analysis of a stock involves looking at a company’s underlying business metrics, such as its revenue, earnings and debt. Technical analysis, on the other hand, involves looking only at a stock’s recent price movements and identifying buy and sell signals in its chart.
What is Technical Analysis?
While it may seem counterintuitive, technical analysts don’t typically care about what product or service a company sells or anything else about the company’s business. Instead, technical analysts are only interested in two things: stock price and volume.
Technical analysts look for patterns in a stock’s chart that signal where its share price could be headed next.
Modern technical analysis dates back to Charles Dow in the late 1800s. In a nutshell, the Dow Theory identified 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.
The idea that a trader can look at a pattern of past price performance and predict that pattern will continue is the basis of TA.
How Does Technical Analysis Work?
Fundamental analysts often criticize TA as a sort of mysticism or pseudoscience. After all, the idea that stock charts hold some sort of predictive power may not make sense on the surface.
First, many technical analysts would say the patterns traders identify in charts aren’t directly influencing the future stock price. Instead, they merely represent a visual representation of a pattern of underlying market activity that actually is directly influencing future share price.
For example, shifts in investor sentiment often manifest as a particular pattern in a stock’s chart, such as a head-and-shoulders formation. The head-and-shoulders formation doesn’t have magical power over the stock price. It is merely a visual representation that a majority of traders have flipped from bullish to bearish.
In addition, TA can become a self-fulfilling prophecy. If enough traders recognize a particular pattern as bearish, they will sell or short the stock when they see it. That belief alone can create enough selling pressure to move a stock lower.
TA Strategies For Beginners
One popular TA trading strategy is the moving average crossover strategy. Traders typically buy a stock when its 50-day simple moving average crosses above its 200-day simple moving average.
They then sell or short the stock when the 50-day SMA drops back below the 200-day SMA.
Another common TA trading strategy involves the relative strength index. RSI is a measure of short-term momentum that varies from zero to 100. RSI traders typically sell or short “overbought” stocks when RSI is above 70 and buy “oversold” stocks when the RSI drops below 30.
TA traders also look for historically bullish and bearish patterns in stock charts that serve as signals of when to buy or sell a stock. Head-and-shoulders, flags, wedges, cup-and-handles and double/triple tops and bottoms are common examples of these patterns.
Most technical analysts will tell beginners that TA works if it is used properly and safely. However, no trading system is 100% perfect, and TA is certainly not a path to getting rich quick in the market.