What is Technical Analysis?
Technical analysis can seem intimidating at first, with all of the charts and the trend lines and the moving averages, but really it’s quite simple. You just need to understand how technical analysis works so you can make an informed decision about your investments. Read on to learn what technical analysis is, how it’s used by stock market investors, and how you can use it to improve your own investing strategy.
How Does Technical Analysis Work?
Technical analysis, also known as charting or technical market analysis, is a method of evaluating securities and forecasting their future price movements. Technical analysts believe that historical price trends contain information about an asset’s future price movement; specifically, that past performance informs your decision about whether or not to buy (or sell) at any given point in time.
Technical analysis uses two types of indicators: lagging indicators, which are based on old data such as the prices over the last week or so; and leading indicators, which anticipate what might happen next by looking for changes in demand levels. Leading indicators include things like volume levels and moving averages.
For example, if the stock trades above its 50-day moving average with increasing volume then it could be considered bullish because it means people are buying more of the stock than they're selling - this suggests there will be continued demand for the stock and thus increased likelihood that its price will continue to rise. Conversely, if the stock is trading below its 50-day moving average with decreasing volume then it could be considered bearish because it means people are selling more of the stock than they're buying - suggesting there will be less demand for the stock and decreased likelihood that its price will increase.
Market indicators as tools
Technical analysts look at market indicators in order to get an understanding of what is going on with a security or an entire market. Some of these include volume, price charts, and moving averages. The key here is that all technical indicators have a connection to something in real life.
For example, price charts show how much people are willing to pay for an asset, and moving averages help smooth out volatility. Every investor has his or her own preferences when it comes to technical indicators but generally speaking, technicians favor those that have historical precedents because they tend to be less arbitrary than purely mathematical models.
Technical Analysis Indicators
One of the most common forms of technical analysis, moving averages work as both a standalone analytical tool and as an indicator in support of other strategies. Whether it’s used on its own or as a component in another strategy, one thing that sets moving averages apart from other indicators is that they are data-driven rather than opinion-based. The moving in moving average refers to how it reacts to market changes, with each new piece of data updating what's called an exponential moving average (EMA). In financial markets, EMA’s are widely used for their ability to identify trends and smooth out volatility.
They are technical indicators developed by John Bollinger, who wanted to address some of the shortcomings he saw in earlier indicators like moving averages. Bollinger bands consist of three lines—two outer parallel ones (above and below a central line) and an inner one, which is a simple average of price action over a set period of time. The idea is that when prices move up or down beyond these bands it suggests volatility. When prices are at the top of their range and near the upper band, they may be nearing exhaustion. When they’re at the bottom and close to the lower band, they may be nearing exhaustion as well.
The Relative Strength Index (RSI)
RSI is a momentum indicator that compares a security’s price movement over time. It indicates overbought or oversold levels and attempts to determine when market momentum (the rate at which prices are moving) is fading or building. A reading of 70 percent on the RSI means that prices have been rising steadily for some time; however, it also means that an upward correction is overdue. If stocks continue moving upward, even at a slowing pace, then higher levels should be expected. A reading below 30 percent on the RSI means that downward pressure on stock prices has intensified; if stocks remain at lower levels for some time, watch out below! Readings above 70 percent can mean an overheated market, while readings below 30 percent may indicate undervalued security.
Technical analysis is an extremely broad topic that encompasses a vast array of different charting techniques. With so many methods available, it can be hard to find one that works for you. After reading through all of these techniques, I hope that you have gained some insight into which technical indicators work best with your trading style. Whatever path you choose to take, remember that it’s important to remain open-minded and flexible when it comes to your approach.