Technical analysis is a method of evaluating securities by analyzing the statistics generated by market activity, such as past prices and volume. Technical analysts do not attempt to measure a security's intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity.
Just as there are many investment styles on the fundamental side, there are also many different types of technical traders. Some rely on chart patterns, others use technical indicators and oscillators, and most use some combination of the two. In any case, technical analysts' exclusive use of historical price and volume data is what separates them from their fundamental counterparts. Unlike fundamental analysts, technical analysts do not care whether a stock is undervalued - the only thing that matters is a security's past trading data and what information this data can provide about where the security prices might move in the future.
All technical analysis is based on three assumptions:
- The market discounts everything.
- Price moves in trends.
- History tends to repeat itself.
THE MARKET DISCOUNTS EVERYTHING
A major criticism of technical analysis is that it only considers price movements, ignoring the fundamental factors of the company. However, technical analysis assumes that, at any given time, a stock's price reflects everything that has or could affect the company - including fundamental factors. Technical analysts believe that the company's fundamentals, along with broader economic factors and market psychology, are all priced into the stock, removing the need to actually consider these factors separately.
PRICE MOVES IN TRENDS
In technical analysis, price movements are believed to follow trends. This means that after a trend has been established, the future price movement is more likely to be in the same direction as the trend than to be against it. Most technical trading strategies are based on this assumption.
HISTORY TENDS TO REPEAT ITSELF
Another important idea in technical analysis is that history tends to repeat itself, mainly in terms of price movements. The repetitive nature of price movements is attributed to market psychology; in other words, market participants tend to provide a consistent reaction to similar market stimuli over time. Technical analysis uses chart patterns to analyze market movements and understand trends. Although many of these charts have been used for more than a 100 years, they are still believed to be relevant because they illustrate patterns in price movements that often repeat themselves. One of the most important concepts in technical analysis is that of trend. Its meaning in the context of finance isn't all that different from the general definition of the term - a trend is really nothing more than the general direction in which a security or the market is headed.
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