Technical analysis is a trading strategy used by many investors for many different reasons. It's a somewhat controversial school of thought, but technical analysis has its proponents.
That's why we think a well-rounded investing education requires an understanding of this complex and sometimes divisive financial concept.
So, what is technical analysis, and how might you use it as part of your investing strategy?
An introduction to technical analysis
Technical analysis was founded by one of the most famous names in stock market history: Charles Dow. He 'invented' the first market index, the Dow Jones Industrial Average (INDEXDJX: .DJI), and the concept of technical analysis.
Dow first likened share market trends to the movements of the ocean. Long-term bull and bear markets were 'tides', and the short-term movements were 'waves'. With input from other theorists and market participants, technical analysis was born from these ideas.
Technical analysis refers to statistical trends gathered from trading activity to determine possible investing or trading opportunities. Technical analysts will look at share price charts and graphs to find patterns that indicate specific trends. It's sometimes referred to as 'charting' for this reason.
Technical analysis uses data from the past to predict share price movements. Thus, investors can use almost any share for technical analysis — all that is needed is a track record of trading on a stock exchange.
Unlike its rival fundamental analysis, technical analysis focuses more on pricing and trade volumes. It eschews the underlying business fundamentals of a share to determine whether an investment should or shouldn't occur.
For example, a technical analyst will be far more concerned with a share's momentum or volatility than the company's earnings growth rate or profitability.
Key assumptions of technical analysis
The field of technical analysis relies on three key assumptions that support the theory's validity.
The first is an inherent acceptance of the 'efficient market' hypothesis. This represents the idea that the market is almost always 100% efficient in its pricing mechanisms, incorporating all of the publicly available and relevant information on a company and its share price.
Because of this belief in the market's efficiency, a technical analyst doesn't support the theory that analysing a share's fundamentals can produce a 'market-beating' outcome. Therefore, it is believed that technical analysis is far more helpful in determining both a share price's short and long-term future. Or so the theory goes.
The second assumption is that the vast majority of all share price movements occur within a trend — even the movements that appear erratic or volatile. This trend might be short or long-term, but a technical analyst will always assume that a share price movement can be explained by looking at the past. In this way, a technical analyst can use these trends to build a trading strategy.
The third assumption is that a share's past trends tend to repeat themselves, often in a cyclical manner. For example, trends following buying and selling pressure are typically very similar over periods of time.
A typical pricing pattern that a technical analyst might observe is: A share price may move away from and back to a long-term average in a wave pattern. It may spend a month rising above a pricing average (such as a 90-day moving average) and a week falling back to this support level repeatedly.
As such, the analyst can predict when will be a good time to buy or sell based on these patterns or trends.
When should investors use this method?
Technical analysis is a controversial school of thought, and many investors go their whole lives without using it once, often with excellent results.
Here at the Fool, we don't use technical analysis because we don't subscribe to the notion that markets are always efficient, which is one of the central tenets of technical analysis. Instead, we Foolishly invest based on a company's fundamentals and business strength rather than what a chart tells us.
But that's just us. There are unquestionably useful components of technical analysis, but many critics decry this discipline as simply a result of the 'self-fulfilling prophecy' effect. If enough investors believe in and practise technical analysis, the pricing movements that the discipline highlights will indeed indicate some future trends.
Even so, many investors use charting and technical analysis, often combined with fundamental investing techniques.
Technical analysis can help predict a share's short-term pricing moves if you've already decided on a 'buy price' using fundamental analysis, for example.
In trading decisions, there is never a 'right' or 'wrong' way to invest as long as it works for you and delivers good results.
