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Technical Analysis: Know when to jump in (or pull out)

There are many ways that investors can evaluate potential or current investment positions, such as those in the stock market, in the hopes of determining the assets worth investing in, and the ideal timing to maximize returns. There are often two different approaches that are discussed in parallel, especially with regard to stock trading, and we discuss below the methodology called technical analysis. 

What is technical analysis?

In a nutshell, technical analysis looks into past stock market data in order to predict future price moves. It is a tool in trading that is used to evaluate assets and securities by crunching trading activity statistics like price movements and volume.

The end goal of technical analysis of a market is to determine when and where to best enter a trading position. As well as (and perhaps more importantly), when and where to exit a position.

Technical analysis vs. Fundamental analysis

Technical analysis is often compared to fundamental analysis, which looks into factors such as revenues, costs, inflation, and socio-political matters. Most traders would choose to specialize in either technical or fundamental analysis, while some (especially banks and brokerages) incorporate both methods to make more informed investment decisions. 

Remember that the more quality information you have, the better your trading results could be. For example, you might utilize fundamental analysis and come to the decision to buy into a market. You might then use technical analysis to identify specific good, low-risk entry points for specific stocks or investments.

Approaches to technical analysis

There are two approaches to technical analysis:

Top-down

Often used by short-term traders, this approach involves first drawing up certain technical criteria, and then finding specific stocks whose characteristics fit into these criteria.

Bottom-up

Common with longer-term traders, this approach starts with a particularly-interesting stock, and then applying technical analysis to look for any potential entry and exit points.

Assumptions in technical analysis

As mentioned in another Academy article, both day traders and swing traders consider the technical analysis methodology practical, based on these two primary assumptions:

1. Price history tends to be cyclical

Market history has a tendency to repeat itself, perhaps not perfectly, but clear short- and long-term patterns have generally been observed. And if market behavior is indeed repeatable, then we should be able to reasonably predict price patterns based on past data.

Technical analysts can therefore focus on locating trade opportunities based on the oscillation of stock prices, and better identify situations wherein the risk/reward is favorable.

2. Prices run in distinct trends

Another major assumption that is applied to technical analysis is that price movements in any direction are never just random. Chaos theory tells us there will always be logical and identifiable patterns that would make it easier to both explain and forecast stock price trends.

A macro example of this can be seen in the distinct and inevitable cycling between investor pessimism and optimism in bear markets and bull markets, respectively.

Charts used in technical analysis

In trying to piece together the story behind price movements, technical analysts generally look for clues in stock charts. Charts visually represent stock prices when trades are executed, and the most common type of charts used by technical analysts is the candlestick chart.

In this type of chart, each “candlestick” represents a designated time segment, and records the stock’s starting price (open), highest price (high), lowest price (low), and final price (close) during that period.

The interval between the open and close is usually shaded red or green, depending on whether the price closed higher or lower than it opened, indicating the direction of the price movement.

Indicators used in technical analysis

Technical analysts make use of a number of indicators and metrics in order to identify trends in the market based on charts and historical data. Here are some examples of the common price and momentum indicators used in technical analysis:

  • Simple moving average (SMA): calculated based on the closing prices within a designated time period
  • Exponential moving average (EMA): a modification of SMA that puts more weight on recent closing prices
  • Relative strength index (RSI): an oscillator that applies a formula to pricing data to produce results between 0 and 100
  • Bollinger bands (BB): add two lateral bands around a moving average line to identify overbought/sold conditions and measure volatility
  • Moving average convergence difference (MACD): produced by subtracting two EMAs, resulting in an MACD line. This is in turn used to create a new EMA, which results in a “signal” line.
  • MACD histogram: generated based on the differences between a MACD line and a signal line.

Limitations of technical analysis

Some critics question the legitimacy of technical analysis on the basis of the efficient markets hypothesis. This economic principle states that market prices already reflect current and historical price and volume data, which means we can’t really derive actionable information from patterns in order to earn extra profits. 

Another criticism of technical analysis is that it often works as a self-fulfilling prophecy. Consider how if several traders just happen to all set the same 100-day moving average of a stock as a selling point, and they do sell a large number of stocks when the price reaches this level.

This would push the stock further down, and other traders who only see the price collapse would also sell off their positions. This would reinforce the first group’s belief that they guessed correctly through technical analysis, when in fact, they caused the movement, themselves.

Conclusion

There is no secret combination of indicators and charts that will magically reveal the perfect trading strategy. Experienced (and successful) traders are always on the lookout for signs that their indicators are misleading.

Anyone can make a lucky guess once in a while, but the real key to smart and sustainable trading is proper risk management, patience, and the discipline to keep your emotions in check. This can also protect you when the market turns its back on you.

With a little time and effort, you could be on your way to applying technical analysis to reap big rewards from the stock market.

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