Technical Analysis
Explore the foundational concepts of technical analysis, charting techniques, and analytical tools that empower traders and investors to navigate the financial markets with confidence.
Last updated
Explore the foundational concepts of technical analysis, charting techniques, and analytical tools that empower traders and investors to navigate the financial markets with confidence.
Last updated
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Technical analysis has to do with forecasting future financial price movements based on past price movements. Think of technical analysis like weather forecasting—it doesn't result in absolute predictions. Instead, technical analysis can help investors anticipate what is “likely” to happen to prices over time.
Technical analysis can be applied to stocks, indexes, commodities, futures, or any tradable instrument where the price is influenced by supply and demand. Price data (or, as John Murphy calls it, “market action”) refers to any combination of the open, high, low, close, volume, or open interest for a given security over a specific timeframe. The timeframe can be based on intraday (1-minute, 5-minutes, 10-minutes, 15-minutes, 30-minutes, or hourly), daily, weekly, or monthly price data, lasting a few hours or many years.
Technical analysis can be applied to charts that show price action over time. The chart below shows a weekly chart of Alphabet Inc. (GOOGL). A weekly chart provides a long-term view of price movement. In the chart of GOOGL, you can see an uptrend and downtrend.
Below is a daily chart of GOOGL, which shows a shorter-term view of the stock's price action.
Technical analysis can be applied to securities where the price is influenced by the forces of supply and demand. When other forces influence the price of a security, technical analysis may not work well. To be successful, technical analysis makes three key assumptions about the securities that are being analyzed:
Liquidity. Heavily-traded stocks allow investors to trade quickly because there are many buyers and sellers. Thinly-traded stocks are more difficult to trade because there are few buyers or sellers. So, if you're trying to trade a thinly traded stock, you may have to change your entry or exit price considerably to make a trade. In addition, low-liquidity stocks often trade at a low price (sometimes less than a penny per share), which means that their prices are easier to manipulate. These outside forces acting on thinly-traded stocks make them unsuitable for technical analysis.
No Artificial Price Changes. Splits, dividends, and distributions are the most common “culprits” for artificial price changes. Though there's no difference in the value of the investment, artificial price changes can dramatically affect the price chart and make technical analysis difficult to apply. This kind of price influence from outside sources can be easily addressed by adjusting the historical data before the price change.
No Extreme News. Technical analysis cannot predict extreme events, such as a change in management, regulatory changes, and geopolitical events. When the forces of “extreme news” influence price, technicians have to wait patiently until the chart settles down and starts to reflect the “new normal” that results from such news.
It's important to determine whether or not a security meets these three requirements before applying technical analysis. That's not to say that analysis of any stock whose price is influenced by one of these outside forces is useless, but it will affect the accuracy of that analysis.
At the turn of the century, the Dow Theory laid the foundations for what would later become modern technical analysis. Dow Theory wasn't presented as one complete amalgamation but rather pieced together from the writings of Charles Dow over several years. Of the many theorems put forth by Dow, three stand out:
Price discounts everything
Price movements are not random
“What” is more important than “Why.”
Let's look at each of these.
This theorem is similar to the strong and semi-strong forms of market efficiency. Technical analysts believe that the current price fully reflects all information. Because all information is already reflected in the price, it represents the fair value and should form the basis for analysis. After all, the market price reflects the sum knowledge of all participants—investors, portfolio managers, buy-side analysts, sell-side analysts, market strategists, technical analysts, fundamental analysts, and many others. It would be folly to disagree with the price set by such an impressive array of people with impeccable credentials. Technical analysis utilizes the information captured by the price to interpret what the market is saying with the purpose of forming a view of the future.
Most technicians agree that prices trend. Yet, most technicians also acknowledge that there are times when prices don't trend. If prices were always random, it would be difficult to make money using technical analysis. In his book, Schwager on Futures: Technical Analysis, Jack Schwager states:
“One way of viewing the situation is that markets may witness extended periods of random fluctuation, interspersed with shorter periods of nonrandom behavior… The goal of the chart analyst is to identify those periods (i.e. major trends).” (p. 12)
A technical analyst believes that it's possible to identify a trend, invest, or trade based on the trend and make money as the trend unfolds. Because technical analysis can be applied to different timeframes, it's possible to spot short- and long-term trends.
The chart of ORCL illustrates Schwager's view on the nature of the trend. The broad trend is up, but it's also interspersed with trading ranges. In between the trading ranges are smaller uptrends within the larger uptrend. When the stock price breaks above the trading range, the uptrend is renewed. When the stock price breaks below the low of the trading range, a downtrend begins. In the chart above, price broke below the trading range, but it was a short-lived downtrend. The uptrend resumed until the next trading range.
In his book, The Psychology of Technical Analysis, Tony Plummer paraphrases Oscar Wilde by stating, “A technical analyst knows the price of everything, but the value of nothing”. Technicians, as technical analysts are called, are only concerned with two things:
What is the current price?
What is the history of the price movement?
The price of a security is the end result of the battle between the forces of supply and demand. The objective of the analysis is to forecast the direction of the future price. By focusing on price, technical analysis represents a direct approach. Fundamentalists are concerned with why the price is what it is. For technicians, the why portion of the equation is too broad and many times the fundamental reasons given are highly suspect. Technicians believe it's best to concentrate on what and never mind why. Why did the price go up? There were simply more buyers (demand) than sellers (supply). After all, the value of any asset is only what someone is willing to pay for it. Who needs to know why?
Many technicians apply a top-down approach that begins with broad-based market analysis, then narrows down to specific sectors/industries, and ultimately analyzes individual stocks.
The beauty of technical analysis lies in its versatility. Because the principles of technical analysis are universally applicable, each of these levels of analysis can be performed using the same theoretical background. You don't need an economics degree to analyze a market index chart. You don't need to be a CPA to analyze a stock chart. Charts are charts. It doesn't matter if the timeframe is two days or two years. It doesn't matter whether you're looking at a stock, market index, or commodity. The technical principles of support, resistance, trend, trading range, and other aspects can be applied to any chart. As simple as this may sound, technical analysis is far from easy. Success requires serious study, dedication, and an open mind.
Technical analysis can be complex or straightforward. It depends on how you use it. The example below shows some basic principles of chart analysis. Since you're probably interested in buying stocks, the focus will be on spotting bullish situations in this chart.
Overall Trend. The first step is to identify the overall trend. You can do this with trend lines, moving averages, or peak/trough analysis. For example, as long as price remains above its upward-sloping trend line or specific moving averages, the trend is up. Similarly, the trend is up as long as higher lows form on pullbacks and higher highs form on advances.
Support. Congestion areas and previous lows below the current price mark the support levels. A break below support would be considered bearish and detrimental to the overall trend.
Resistance. Congestion areas and previous highs above the current price mark resistance levels. A break above resistance would be considered bullish and positive for the overall trend.
Momentum. Momentum is usually measured with an oscillator such as MACD. If MACD is above its 9-day EMA (exponential moving average) or positive, momentum will be considered bullish or at least improving.
Buying/Selling Pressure. For stocks and indices with volume figures available, an indicator that uses volume is used to measure buying or selling pressure. When the Chaikin Money Flow is above zero, buying pressure is dominant. Selling pressure is dominant when it is below zero.
Relative Strength. The price relative is plotted as a line that divides the security by a benchmark. For stocks, the price is usually divided by the S&P 500. The relative strength plot indicates if the stock is outperforming (rising) or underperforming (falling) the major index.
The final step is to synthesize the above analysis to ascertain the following:
Strength of the current trend.
Maturity or stage of the current trend.
Reward-to-risk ratio of a new position.
Potential entry levels for a new long position.
The example above analyzed the chart for an individual stock, but these techniques can be applied to sectors or broad market indexes.
Many technicians employ a top-down approach to technical analysis, starting with broad-based macro analysis and ending with a more focused/micro perspective:
Broad market analysis using major indices such as the S&P 500, Dow Industrials, NASDAQ and NYSE Composite.
Sector analysis to identify the strongest and weakest groups within the broader market.
Individual stock analysis to identify the strongest and weakest stocks within select groups.
For each segment (market, sector, and stock), an investor would analyze long-term and short-term charts to find those that meet specific criteria. Analysis will first consider the market in general, perhaps the S&P 500. If the broader market were considered to be in bullish mode, analysis would proceed to a selection of sector charts.
Those sectors that show the most promise would be singled out for individual stock analysis. Once the sector list is narrowed to 3-4 industry groups, individual stock selection can begin.
With a selection of 10-20 stock charts from each industry, a selection of 3-4 of the most promising stocks in each group can be made. How many stocks or industry groups make the final cut will depend on the strictness of the criteria set forth. Under this scenario, we would be left with 9-12 stocks from which to choose. These stocks could even be broken down further to find the 3-4 that are the strongest of the strong.
If the objective is to predict the future price, then it makes sense to focus on price movements. Price movements usually precede fundamental developments. By focusing on price action, technicians are automatically focusing on the future. The market is considered a leading indicator and generally leads the economy by six to nine months. It makes sense to look directly at the price movements to keep pace with the market. More often than not, change is a subtle beast. Even though the market is prone to sudden knee-jerk reactions, hints usually develop before significant moves. A technician will refer to periods of accumulation as evidence of an impending advance and periods of distribution as evidence of an impending decline.
Many technicians use the open, high, low and close when analyzing the price action of a security. There is information to be gleaned from each bit of information. Separately, these will not be able to tell much. However, taken together, the open, high, low, and close reflect forces of supply and demand.
The annotated example above shows a stock that opened with a gap up. Before the open, the number of buy orders exceeded the number of sell orders and the price was raised to attract more sellers. Demand was brisk from the start. The intraday high reflects the strength of demand (buyers). The intraday low reflects the availability of supply (sellers). The close represents the final price the buyers and sellers agreed upon. In this case, the close is well below the high and much closer to the low. This tells us that even though demand (buyers) was strong during the day, supply (sellers) ultimately prevailed, forcing the price back down. Even after this selling pressure, the close remained above the open. Looking at price action over an extended period, you can see the battle between supply and demand unfold. In its most basic form, higher prices reflect increased demand, and lower prices reflect increased supply.
Simple chart analysis can help identify support and resistance levels. These are usually marked by periods of congestion (trading range) where the prices move within a confined range for an extended period, telling us that the forces of supply and demand are deadlocked. When prices move out of the trading range, it signals that either supply or demand has started to get the upper hand. If prices move above the upper band of the trading range, then demand is winning. If prices move below the lower band, then supply is winning.
Even if you are a tried and true fundamental analyst, a price chart can offer plenty of valuable information. The price chart is an easy-to-read historical account of a security's price movement over a period of time. Charts are much easier to read than a table of numbers. On most stock charts, volume bars are displayed at the bottom. With this historical picture, it is easy to identify the following:
Reactions prior to and after important events.
Past and present volatility.
Historical volume or trading levels.
Relative strength of a stock versus the overall market.
Technical analysis can help with timing a proper entry point. Some analysts use fundamental analysis to decide what to buy and technical analysis to decide when to buy. It is no secret that timing can play an important role in performance. Technical analysis can help spot demand (support) and supply (resistance) levels as well as breakouts. Simply waiting for a breakout above resistance or buying near support levels can improve returns.
It is also important to know a stock's price history. If a stock you thought was great for the last 2 years has traded flat for those two years, it would appear that Wall Street has a different opinion. If a stock has already advanced significantly, it may be prudent to wait for a pullback. Or, if the stock is trending lower, it might pay to wait for buying interest and a trend reversal.
Just as with fundamental analysis, technical analysis is subjective and our personal biases can be reflected in the analysis. It is important to be aware of these biases when analyzing a chart. If the analyst is a perpetual bull, then a bullish bias will overshadow the analysis. On the other hand, if the analyst is a disgruntled perma-bear, then the analysis will probably have a bearish tilt.
Furthering the bias argument is the fact that technical analysis is open to interpretation. Even though there are standards, many times two technicians will look at the same chart and paint two different scenarios or see different patterns. Both will be able to come up with logical support and resistance levels as well as key breaks to justify their position. While this can be frustrating, it should be pointed out that technical analysis is more like an art than a science, akin to economics. Is the cup half-empty or half-full? It is all in the eye of the beholder.
Technical analysis has been criticized for being too late. By the time the trend is identified, a substantial portion of the move has already taken place. After such a large move, the reward to risk ratio is not great. Lateness is a particular criticism of Dow Theory.
Even after a new trend has been identified, there is always another “important” level close at hand. Technicians have been accused of sitting on the fence and never taking an unqualified stance. Even if they are bullish, there is always some indicator or some level that will qualify their opinion.
Not all technical signals and patterns work. When you begin to study technical analysis, you will come across an array of patterns and indicators with rules to match. For instance: A sell signal is given when the neckline of a head and shoulders pattern is broken. Even though this is a rule, it is not steadfast and can be subject to other factors such as volume and momentum. In that same vein, what works for one particular stock may not work for another. A 50-day moving average may work great to identify support and resistance for IBM, but a 70-day moving average may work better for Yahoo. Even though many principles of technical analysis are universal, each security will have its own idiosyncrasies.
Technical analysts consider the market to be 80% psychological and 20% logical. Fundamental analysts consider the market to be 20% psychological and 80% logical. Psychological or logical may be open for debate, but when it comes to the price of a security, there's nothing to question. It's available for all to see. Nobody doubts its legitimacy. The price set by the market reflects the sum knowledge of all participants. We're not dealing with lightweights here. These participants have considered (discounted) everything under the sun and settled on a price to buy or sell. These are the forces of supply and demand at work. By examining price action to determine which force is prevailing, technical analysis focuses directly on the bottom line: What is the price? Where has it been? Where is it going?
Even though there are some universal principles and rules that can be applied, remember that technical analysis is more of an art form than a science. As an art form, it's subject to interpretation. However, it's also flexible in its approach, and each investor should use only that which suits his or her style. Developing a style takes time, effort, and dedication, but the rewards can be significant.
