Investing Basics: Technical Analysis

Last week we took a look at fundamental analysis as part of our Investing Basics series. This is not the only type of “analysis” that you can use to determine whether or not you want to invest in a particular vehicle. There is also a mode of analysis called technical analysis. When you engage in technical analysis, you look at a more narrow range of factors. Technical analysis is, well, technical. It’s all about the numbers, volume and what an investment is doing now – and what it was doing in the past.

What is technical analysis?

Technical analysis is all about price movements and volume trends on the market. Those who subscribe to technical analysis are sometimes called chartists or technicians. Technical analysis relies heavily on daily movements in the stock market, volume, charts that encompass long-term and short-term trends. It looks for patterns in price action. Technical analysis doesn’t care about the ethics of a company, its management or any of the other “big picture” items that fundamental analysis considers. Instead, there is only the price movement and the volume trends. The idea is to interpret the hard data of performance in such a way that you can see trends in an investment’s movements and buy or sell according to what is likely to happen. Additionally, technical analysis views price action as a result of investor behavior. Technical analysis can get complex, so we’ll just cover most of the basics here.

First of all, there are three main assumptions that are made when using technical analysis:

1. Investment prices move in trends. Once a trend has been established, investment prices are likely to move in the same direction. Long-term, technical analysis assumes that an investment is much more likely to move with an overall trend than against it. When a trend comes to a close, it is replaced by the formation of a new trend – one that may move in a new direction.
2. The market encompasses everything. Because technical analysis looks at price movement to the exclusion of everything else, many chartists assume that even fundamental factors and market psychology are priced in to investment performance. Market price is assumed to be the final word in an investment’s value, including investor sentiment.
3. History repeats itself. Price movement trends will repeat themselves. Indeed, some charts have been used for more than a century. But that is acceptable since at some point price movements are likely to manifest again.

Some critics of technical analysis disagree with some (or all) of these assumptions. However, there are chartists who do very well using technical analysis.

Trends and technical analysis

There are three types of trend to be considered in technical analysis: up, down and sideways. While an uptrend and a downtrend are fairly obvious, a sideways trend probably needs a little explanation. A sideways trend is one that appears to be going nowhere. Peaks and troughs on the chart remain at roughly the same level, rather than moving successively higher or lower. A sideways trend is, at its most basic, the lack of any defined trend. There are also trend lengths to consider. Short, medium and long term trends are studied. Part of technical analysis is understanding these trends, looking for their formation and then adjusting the entry and exit points of your trade according to what is most likely to give you the best chance of profit. When using technical analysis, your exit is as important as your entry.

Support, resistance and moving averages

Other important technical analysis concepts are those of support, resistance and moving averages. Support is the floor. It is the lowest level of the trend. When the price does gets near this lower level several times, but does not breach it, a base is formed. Resistance is the ceiling. This is the price level that the investment can’t seem to break through. It’s considered a victory when a price breaks through the resistance and then actually manages to form a new basis of support. On the other hand, if an investment breaks through the lower support level, the low becomes the new resistance level. Trends and reversals represent sentiment, and can be indicators of investor psychology.

Moving averages are used to smooth out the sometimes-volatile appearing day-to-day trends. The idea is to get a better view of the trend. Day traders can use moving averages to help smooth out hourly fluctuations. The idea is to plot the average price of an investment to get a better view of the trend. There are three main types of moving averages:

1. Simple moving average represents the most common way of calculation price moving averages. The traders adds up all of the closing prices over a set period of time (10-day, 3-month, 52-week, etc.) and then divides them to arrive at an average.
2. Exponential moving average is weighted so that recent data points are more important. It takes new information into account and involves complex calculations to help smooth out the appearance of the chart. Most traders just have whatever chart package they are using calculate this when they want to know it.
3. Linear moving average is the least used of moving averages. It takes the closing prices over time, multiplies them by the position of the data point and then divides by the sum of the closing prices. If you had three days, today’s closing price would be multiplied by three, yesterday’s by two and the day before would be left alone. All of those results would be added together and then divided by the sum of all the unadulterated closing prices.

Moving averages can be used to quickly identify a trend – or an emerging trend. They can also be used to find crossovers. These are points that mark a change in the direction of a trend. You can also use leading and lagging indicators to determine whether an investment is heading into a price change (leading), or to confirm a trend you already see (lagging).

Many people use technical analysis for day trading and other short-term trading, although it can be adapted for long-term use. And technical analysis can be used in conjunction with fundamental analysis to gain a more complete picture of an investment’s prospects.