Understanding Technical Analysis in Stock Investing

Security analysis methodology.

Technical analysis is a method of evaluating securities by analyzing statistics generated by market activity, such as past prices and volume. Unlike fundamental analysts, who attempt to evaluate a security's intrinsic value, technical analysts focus on charts of price movement and various analytical tools to evaluate a security's strength or weakness.

Principles of Technical Analysis

Technical analysis is based on three key principles:

1. Market action discounts everything: This principle assumes that a stock's price reflects everything that has or could affect a 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.

2. Prices move in trends: Technical analysts believe that prices trend directionally, i.e., up, down, or sideways (flat) over time.

3. History tends to repeat itself: Technical analysts believe that historical price movements tend to repeat themselves. 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.

Reading Stock Charts and Identifying Patterns

Technical analysis involves the use of various methods for charting, calculating and interpreting graph patterns. It's about finding and recognizing repetitive patterns that can indicate future activity. Some of the most common patterns include:

• Head and Shoulders: This pattern is often a signal that a downward trend is about to reverse into an upward trend.
• Cup and Handle: This pattern is a bullish signal that shows a period of bearish market sentiment before the trend reverses to an upward trend.
• Double Top and Double Bottom: These patterns signal that the trend in either direction is about to reverse.

Key Technical Indicators

Technical indicators are used to predict future price levels or overall price direction. Some of the most common technical indicators include:

• Moving Averages: This indicator shows the average value of a security's price over a period of time and can help identify trends and reversals.
• Relative Strength Index (RSI): This momentum oscillator measures the speed and change of price movements. RSI is often used to identify overbought or oversold conditions in a market.
• Volume: This measures the number of shares traded in a security. It is often used in conjunction with price analysis to confirm trend strength or highlight its weakness.

Limitations and Criticisms of Technical Analysis

While technical analysis can be a useful tool, it is not without its critics. Some investors believe that this method of analysis is akin to "reading tea leaves". Critics argue that the efficacy of technical analysis is a psychological effect and is not indicative of future results.

In conclusion, technical analysis can be a useful tool in your investing toolkit, but it should not be the only method used to make investment decisions. It's important to consider a variety of factors, including the company's fundamentals, the state of the economy, and your own risk tolerance and investment goals.