Stock trading is an exciting yet complex endeavor, but traders rely on various strategies to help them navigate the market more confidently and effectively. One such strategy that has stood the test of time is technical analysis, which involves examining volume data and historical price movements to predict future trends. The technical analysis of stocks has been used for hundreds of years, and today, it offers traders valuable insights that can inform their trading decisions and help them succeed in a dynamic market. In this blog, we will break down the concept of technical analysis, and how you can use it for more informed decisions in trading, so read on!
Technical versus fundamental analysis
Technical analysis and fundamental analysis are two essential concepts in the financial landscape, but they are different. With technical analysis, there is a belief that the best approach is to follow the trend when it forms through market action, while with fundamental analysis, the market is considered to overlook value often. Fundamental analysis doesn’t examine chart trends; instead, it relies on digging through a company’s market profile and balance sheet to understand its intrinsic value, which may not be reflected in the price. Many profitable investors have used fundamental or technical analysis ( or both) as part of their trading strategy, and they have reaped significant rewards as a result of doing so. But it’s worth noting that, on the whole, technical analysis is associated with a faster investing pace, while fundamental analysis has a longer holding period since time is needed to conduct extra due diligence.
What are the advantages of technical analysis?
As mentioned in the beginning, technical analysis can be a great tool to help you navigate the stock market more effectively and confidently. One of its biggest benefits is that it is straightforward, meaning that you can use it even if you aren’t a financial expert. All it takes to implement it is to do some easy math and use visuals to understand prices, and then you can make decisions quickly with it. There’s no need to spend too much time trying to decipher complex concepts, as instead, you can find books, online resources and courses to learn the basics, making it easier to enter the stock market.
Technical analysis can indicate the right time to enter or exit a position, helping you make the most of the trading process. This is because accurate timing can boost your chances of decreasing losses as much as possible and maximizing returns. Furthermore, it helps you manage risk effectively, allowing you to identify resistance and support levels and strategically place stop-loss orders. By leveraging technical analysis, you can calculate the risk-to-reward ratio of each of your trades, which essentially compares the profit that you could make to the loss that you could experience.
How do you use technical analysis?
Technical analysis relies on the principle that the market price indicates all the data that could impact the market, meaning that it’s unnecessary to examine fundamental, economic, or new developments. Technical analysts believe that prices fluctuate based on trends and history repeats itself, so the overall market psychology can be determined by keeping these considerations in mind.
There are two major types of technical analysis: technical indicators, and chart patterns. Chart patterns represent a subjective type of technical analysis, with technical aiming to pinpoint areas of support and resistance by analyzing the specific patterns on a chart. These patterns can predict how prices are moving, after a breakdown or breakout from a particular time and price point. For instance, an ascending chart pattern (which is a bullish pattern) indicates a key resistance area and a breakout from this resistance would mean a high volume moving higher.
Technical indicators, on the other hand, represent a statistical form of technical analysis, with technicians applying different mathematical formulas to volumes and prices. The most frequent technical indicators are moving averages, which make it easier to spot trends by smoothing price data. There are, however, more complex technical indicators, like the MACD or the moving average convergence divergence, which considers the interplay between different moving averages. Many trading systems rely on technical indicators as they cannot be calculated quantitatively.
Are there any downsides when it comes to technical analysis?
While technical analysis indeed has its merits, it is by no means perfect and has its set of limitations. First and foremost, technical analysis can lead to subjective judgements, as the interpretation of chart patterns can be different among traders. For instance, while someone may identify a double top pattern, another trader may see it as a rounding top. Moreover, technical analysis is a great tool for short-term trading but may not be so effective when it comes to long-term investing decisions, as it focuses on volume data and price without considering fundamental factors.
One of the weaknesses of technical analysis is that it can give false signals, which can cost you heavily. When an indicator or a trading pattern shows a specific market movement, but the movement is entirely different, that is a false signal, which can be inaccurate or misleading. False signals are very common, and they can take many forms, such as whipsaws (they happen when a moving average crossover shows a buy signal only to be followed by a sell signal), fake breakouts, divergence reversals, MACD ( a momentum indicator showing the relation between two moving averages of the price of an asset), and RSI ( a momentum oscillator measuring the speed and size of ranges from 0-100 and price movements).
Another thing to keep in mind is that traders tend to rely solely on technical analysis, which can lead them to ignore macroeconomic factors and fundamental analysis that can also provide important insights. As a rule of thumb, traders should use technical analysis in combination with fundamental analysis for the best results.
The bottom line
While technical analysis can provide valuable insights into price trends and help you make more profitable trades, it can also come with downsides. Depending solely on it to make decisions regarding your trades can be risky and is therefore not recommended. Instead, the best approach is to combine it with fundamental analysis to ensure a better outcome.