As mentioned in Fundamental Analysis article, there are two methods of reading stocks: fundamental analysis and technical analysis. Fundamental analysis involves analyzing the characteristics of a company in order to estimate its value. Technical analysis takes a completely different approach – it cares only of price movement and graphical signals.
Definition of technical analysis
Technical analysis is a method of evaluating securities by analyzing the data generated by market activity, such as past prices and volume. Technical analysts do not attempt to measure a security’s fundamental value, but instead use charts and other tools to identify patterns that can suggest future activity.
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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 don’t care whether a stock is undervalued – the only thing that matters is a security’s history trading data and what information this data can provide about where the security might move in the future.
The field of technical analysis is based on three assumptions:
1.The market knows everything
2.Price moves in trends
3.History tends to repeat itself
The Market Knows Everything
A major criticism of technical analysis is that it only considers price movement, 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. Which means market knows the fundamental of the companies and it knows what’s going on inside the company. 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 movement. 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 100 years, they are still believed to be relevant because they illustrate patterns in price movements that often repeat themselves.
Technical analysis can be used on any security with historical trading data, this includes stocks, commodities, forex, etc. In fact, technical analysis is more frequently associated with commodities and forex, where the participants are predominantly traders. Nowadays Institutes are spending billions of dollars on mathematical modeling which use various math techniques like regression, Curve fitting n differential equations to predict the market movements. Mathematical models are the future of technical analysis.