What Is Technical Analysis?
Technical analysis is a method of evaluating securities by analyzing statistical data generated by market activity, primarily price and volume. Unlike fundamental analysis, which examines a company's financial statements and intrinsic value, technical analysis focuses on patterns in price charts to forecast future price movements.
The core premise behind technical analysis is that all known information about a security is already reflected in its price. By studying historical price patterns and trading volume, technical analysts believe they can identify trends and predict where prices are likely to move next. This approach is used by day traders, swing traders, and even long-term investors looking to optimize their entry and exit points.
"The market is a pendulum that forever swings between unsustainable optimism and unjustified pessimism." — Benjamin Graham
Technical Analysis vs Fundamental Analysis
Understanding the difference between these two approaches is essential for any investor:
| Aspect | Technical Analysis | Fundamental Analysis |
|---|---|---|
| Focus | Price charts and volume data | Financial statements and business value |
| Data Used | Historical price, volume, patterns | Revenue, earnings, assets, liabilities |
| Time Horizon | Short to medium term | Medium to long term |
| Key Question | When should I buy or sell? | What should I buy or sell? |
| Tools | Charts, indicators, oscillators | Financial ratios, DCF models, industry analysis |
| Philosophy | Price reflects all known information | Market may misprice securities |
| Best For | Active traders and timing entries | Long-term investors selecting companies |
Many successful investors use both approaches together: fundamental analysis to identify quality companies, and technical analysis to determine the optimal time to buy or sell.
Reading Candlestick Charts
Candlestick charts are the most popular chart type among technical analysts. Each candlestick represents a specific time period (one day, one hour, one week, etc.) and displays four key data points:
- Open: The price at the beginning of the time period
- Close: The price at the end of the time period
- High: The highest price reached during the period
- Low: The lowest price reached during the period
The thick part of the candlestick is called the body, which shows the range between open and close. The thin lines extending above and below the body are called wicks (or shadows), showing the high and low. A green (or white) candlestick means the price closed higher than it opened (bullish). A red (or black) candlestick means the price closed lower than it opened (bearish).
Key Candlestick Patterns
- Doji: Open and close are nearly equal, suggesting indecision in the market. Often signals a potential reversal when appearing after a strong trend.
- Hammer: A small body at the top with a long lower wick. Appears during downtrends and suggests potential bullish reversal.
- Engulfing Pattern: A larger candlestick completely engulfs the previous one. A bullish engulfing pattern after a downtrend or bearish engulfing after an uptrend can signal reversals.
- Morning Star / Evening Star: Three-candlestick reversal patterns. The morning star signals a bullish reversal; the evening star signals a bearish reversal.
Support and Resistance
Support and resistance are among the most fundamental concepts in technical analysis:
Support is a price level where a stock tends to stop falling and bounce back up. It represents a concentration of buying interest. Think of it as a floor beneath the price. When a stock approaches a support level, buyers step in, believing the stock is a good value at that price.
Resistance is a price level where a stock tends to stop rising and pull back down. It represents a concentration of selling interest. Think of it as a ceiling above the price. When a stock approaches resistance, sellers take profits, believing the stock has reached a fair or overvalued level.
When a support level is broken, it often becomes a new resistance level, and vice versa. This role reversal is one of the most reliable patterns in technical analysis and helps traders identify meaningful price levels for setting entry points and stop-loss orders.
Trend Lines
Trend lines are straight lines drawn on a chart connecting a series of prices to identify the direction and speed of a price trend. There are three types of trends:
- Uptrend: Characterized by higher highs and higher lows. Draw the trend line along the ascending lows. As long as the price stays above this line, the uptrend is intact.
- Downtrend: Characterized by lower highs and lower lows. Draw the trend line along the descending highs. As long as the price stays below this line, the downtrend is intact.
- Sideways (Range): Price moves horizontally between support and resistance with no clear upward or downward direction. This is also called consolidation.
The most important principle for beginners: trade with the trend, not against it. The old saying "the trend is your friend" remains one of the most reliable guidelines in technical analysis.
Moving Averages
Moving averages smooth out price data to help identify the underlying trend by filtering out short-term noise. They are among the most widely used technical indicators.
Simple Moving Average (SMA)
The SMA calculates the arithmetic mean of prices over a specified number of periods. For example, a 50-day SMA adds up the closing prices of the last 50 days and divides by 50. Common SMAs include the 20-day (short-term trend), 50-day (intermediate trend), and 200-day (long-term trend).
Exponential Moving Average (EMA)
The EMA gives more weight to recent prices, making it more responsive to new information than the SMA. This makes EMAs better for shorter-term trading where recent price action matters more. The 12-day and 26-day EMAs are commonly used in the calculation of the MACD indicator.
Moving Average Crossovers
When a shorter-term moving average crosses above a longer-term moving average, it is called a golden cross and is considered a bullish signal. When the shorter-term average crosses below the longer-term average, it is called a death cross and is considered bearish. The most watched crossover is the 50-day SMA crossing the 200-day SMA.
Common Technical Indicators
Relative Strength Index (RSI)
The RSI is a momentum oscillator that measures the speed and change of price movements on a scale of 0 to 100. An RSI reading above 70 is generally considered overbought (price may be due for a pullback), while a reading below 30 is considered oversold (price may be due for a bounce). The default calculation period is 14 days. RSI is most useful for identifying potential reversal points and confirming trend strength.
Moving Average Convergence Divergence (MACD)
The MACD is a trend-following momentum indicator that shows the relationship between two moving averages. It consists of the MACD line (12-period EMA minus 26-period EMA), the signal line (9-period EMA of the MACD line), and a histogram showing the difference between the two. Bullish signals occur when the MACD line crosses above the signal line; bearish signals when it crosses below.
Bollinger Bands
Bollinger Bands consist of a middle band (typically a 20-day SMA) with an upper and lower band set two standard deviations above and below. The bands expand when volatility increases and contract when volatility decreases. Prices touching or exceeding the upper band may indicate overbought conditions, while touching the lower band may indicate oversold conditions. A "squeeze" (narrow bands) often precedes a significant price move.
Volume
Volume measures the number of shares traded during a given period. It confirms the strength of price movements: a price increase on high volume is more significant than one on low volume. Volume spikes often accompany breakouts from chart patterns or support/resistance levels. Declining volume during a trend may signal weakening momentum and a potential reversal.
Chart Patterns
Head and Shoulders
The head and shoulders pattern is one of the most reliable reversal patterns. It consists of three peaks: a higher middle peak (head) flanked by two lower peaks (shoulders). The pattern signals a reversal from an uptrend to a downtrend when the price breaks below the neckline connecting the two troughs. An inverse head and shoulders signals a bullish reversal.
Double Top and Double Bottom
A double top forms when a stock reaches the same resistance level twice and fails to break through, creating an "M" shape. It signals a bearish reversal. A double bottom forms when a stock reaches the same support level twice and bounces, creating a "W" shape. It signals a bullish reversal. These patterns are confirmed when the price breaks through the neckline between the two peaks or troughs.
Triangles
Triangle patterns form when the price range narrows over time, creating converging trend lines:
- Ascending triangle: Flat upper resistance with rising lower support. Generally bullish, suggesting buyers are becoming more aggressive.
- Descending triangle: Flat lower support with declining upper resistance. Generally bearish, suggesting sellers are becoming more aggressive.
- Symmetrical triangle: Both support and resistance converge. Can break in either direction; traders wait for the breakout to determine direction.
Limitations of Technical Analysis
While technical analysis is a valuable tool, it has important limitations that every investor should understand:
- Not infallible: No indicator or pattern works 100% of the time. False signals are common, and unexpected events can override any technical pattern.
- Self-fulfilling prophecy: Some argue that technical analysis works partly because many traders act on the same signals, creating the predicted movement rather than forecasting it.
- Subjectivity: Different analysts can look at the same chart and draw different conclusions. Pattern recognition involves judgment, not precise measurement.
- Lagging indicators: Many technical indicators are based on historical data and may be slow to signal changes, causing traders to enter or exit positions too late.
- Ignores fundamentals: Technical analysis does not account for a company's financial health, competitive position, or management quality. A stock with a bullish chart pattern may still be a poor investment if the business is deteriorating.
- Works best with liquid securities: Technical analysis is most reliable for heavily traded stocks and indices. Low-volume securities can produce unreliable signals due to thin trading activity.
Getting Started with Technical Analysis
- Learn to read candlestick charts: Master the basics before exploring indicators
- Identify support and resistance: These are the most foundational concepts in chart analysis
- Start with one or two indicators: Avoid cluttering your charts with too many indicators. The RSI and a moving average are a good starting point
- Practice on historical charts: Study how indicators and patterns performed in the past before applying them to live trades
- Combine with fundamental analysis: Use technicals for timing and fundamentals for selection
- Always use risk management: Set stop-loss orders and never risk more than you can afford to lose on any single trade
