After learning fundamental analysis which involves analyzing the nature of business and the characteristics of a company, now let’s look at a completely different approach. It is known as the technical analysis. Fundamental analysis and technical analysis are the 2 main schools of thought in the financial markets. They are like siblings when it comes to analyzing financial securities. Sometimes they work together, sometimes they work on their own, and well like all siblings sometimes they quarrel, and by quarrel, it means that they give different opinions. So, let’s dig deeper to find out more about technical analysis.
Before applying technical analysis, first you have to know what that is.
[Image from: brainstuck.com]
Technical Analysis is a method of analyzing securities by looking and gathering information from the statistics generated by market activity, such as past prices and volume. Generally, it is a forecast of future price movements based on examinations of past price movements. Different from fundamental analysis, it used charts and other tools instead of financial statements to identify patterns that suggest future activity. There are different types of technical traders just like there are different types of approaches in fundamental analysis but technical analysis basically revolves within 3 assumptions:
- The market price discounts everything.
Technical analysis believes that the current stock price in the market will reflect everything that has occurred to the company based on market efficiency theory where market participants have already reacted on the information they had. This is also part of the fair value approach because all information regarding the company like the fundamentals, economic factors, or future prospects are included in the stock price of the company. Therefore, the stock price is more relevant to form a basis for analysis instead of the financial statements that provide historical values. The price information is then gathered to interpret market movements and predict future movements.
- Price movements are not random.
Prices move in trends. There are 3 main trends in technical analysis which are uptrend, downtrend and sideways. As their name implies, uptrend means that in overall, the stock price is moving upwards, downtrend is the reverse of uptrend, and sideways show that the stock price is pretty much stagnant or moving within a certain range. This is pretty straightforward and it is not difficult to spot a trend. Technical analysts often believe that once a trend is formed, the stock price are more likely to follow the trend rather than going against it. This is a useful piece of information when it comes to forecasting future price movements.
- History tends to repeat itself.
This might be a term you will find in social science classes but it is an important concept in technical analysis. Prices are repeated because market participants tend to react consistently given the same market stimuli over time. The repetition of price movements due to factors such as market psychology forms patterns in different size and shapes. We called them chart patterns and they are used to analyze market reaction and understand trends. You might not know what a chart is yet but we will get there soon.
Now, we will move on to the holy grail of technical analysis, which can help you to become a millionaire before you turn 30. Just kidding. There is no such money making mechanism but I will show you the tools used in technical analysis. The most common tool used is charts. A chart is a graphical representation of all the price movements over a period of time. There are 3 different types of charts which are line charts, bar charts and candlestick charts. All type of charts has its own pros and cons but the most common and popular chart among technical traders is the candlestick chart. By the way, these are not the candlesticks you saw in real life!
Candlesticks and candlestick chart, they really do look like candlesticks in real life!
[Images from: www.freeonlinetradingeducation.com & blogs.sas.com]
A candlestick chart is also known as the Japanese candlestick chart as they were used by the Japanese since the 17th century to analyze rice prices. Candlesticks contain data such as the opening price, closing price, highest price, and the lowest price of the day. The image on the upper left shows the 2 main types of candlesticks which are the bullish and the bearish candlestick. If the closing price is higher than the opening price, the candlestick is considered bullish (often shaded green or hollow), and if the closing price is lower than the opening price, the candlestick is considered bearish (often shaded red or black). The image on the upper right shows a typical chart that we will see in all trading platforms nowadays, which consists of many candlesticks in it to record all the previous price movements.
Meet some of the family members of the candlesticks!
[Image from: hitandruncandlesticks.com]
Each candlestick will form different shapes and sizes depending on the four price levels (opening, closing, highest, and lowest) of the stock on a particular day. The image above shows some variations of the candlestick patterns but there are a lot more out there in the market! Different shape and size provide different interpretation and meaning that will affect the decision made by the technical analyst. Some represent bullish behaviour while some represent bearish trends and each with different degrees of strength and momentum. Besides, when two candlesticks come together, they give out different signals as compared to them alone. Below are some examples of what might happen when two different candlesticks come together.
We humans are known as couple when two of us are together but candlesticks get different names. [Image from: singaporestockstrading.com]
After learning some brief introductions of technical analysis, it is important to know that there are some critics that view technical analysis as a form of black magic. There are supporters of this approach and there are those who question the validity and the credibility of technical analysis. However, the truth is that technical analysis does work up to a certain extent. Therefore, as an avid investor, we can’t afford to ignore technical analysis totally.
Although fundamental and technical analysis seemed as polar opposites, many investors have made some great profits by combining the 2 approaches. For technical analysis, we have to master all the chart patterns and other tools in order to have a better profit ratio. We can learn from the success examples and pick up the approach that has a high probability of profit record and those that suit us the most.
Technical analysis requires clear judgement and years of experience but it is do-able!
[Image from: www.wealthmanagement.com]
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Investopedia.com (2006) ‘Technical analysis: The basic assumptions’, in Available at: http://www.investopedia.com/university/technical/techanalysis1.asp (Accessed: 27 January 2017).
Investopedia.com (2006) ‘Technical analysis: Fundamental vs. Technical analysis’, in Available at: http://www.investopedia.com/university/technical/techanalysis2.asp (Accessed: 27 January 2017).
StockCharts (2016) Technical analysis. Available at: http://stockcharts.com/school/doku.php?id=chart_school:overview:technical_analysis (Accessed: 27 January 2017).
Twiggs, C. (2001) Incredible charts: Candlestick charts. Available at: http://www.incrediblecharts.com/technical/candlestick.php (Accessed: 27 January 2017).