If you’re just starting out as an investor or beginning to learn how to trade stocks and shares, you need a plan and a strategy. Understanding the basics of technical analysis is a great way to sharpen your investing skills, giving you a solid trading foundation to build from.
This is one of the main methods used by traders to research potential price movements of assets. The basic concept involves interpreting price and volume charts to spot patterns or movements based on historical data and trading psychology.
It’s mostly used for researching stock trades. But, the techniques can apply to most assets that have enough historical data available. This includes securities such as commodities, currencies (forex), futures, fixed-income assets (bonds) and cryptocurrencies.
We can hear you thinking it: “Wait, what? How about all that ‘Past performance is not indicative of future results’ stuff? How about company performance, market trends and all that? Aren’t they supposed to be important factors to decide whether it’s time to buy or sell?”
Well, the validity of technical analysis is based on two theories:
This means that if, for example, something suddenly goes wrong with a company, technical analysis is not necessarily going to reflect it. Technical analysis only works if condition one is satisfied, that is, if market prices reflect all available information. Whether that’s always true or not, is up for debate.
By looking at statistics and trends in prices and trading volumes, traders use this data to make educated guesses on where the price of an asset could be heading next. The information often relates to relatively short-term movements rather than major long-term trends.
This allows traders to use technical analysis to gauge potential possibilities and outcomes for the price of shares and other assets. However, skilled traders and professional investors will often use other forms of research in addition to technical analysis before making investment decisions.
It’s not an exact science. There are no foolproof formulas or tactics because there are so many variables at play with any single investment. That said, skilled traders can often be fairly accurate with a stated margin of error.
Yet, unexpected things can happen in the markets. Unpredictable factors can influence assets. These events are often not accounted for with technical analysis, meaning that the eventual results can fall way outside the estimated price ranges determined by traders.
This analysis relies on a broad range of patterns and signals. The methods have developed and evolved since the introduction of the first theories by Charles Dow at the end of the 19th century.
The following are the two main types of technical analysis:
Here are some of the major indicators and signals used to support the various theories and methods of trading based on technical analysis:
Here’s a step-by-step overview explaining how you can use technical analysis for trades:
These trading methods and systems have heavily influenced many traders throughout the last hundred years or so. For dedicated traders, technical analysis forms the basic principles used to dictate their theories for the price movement of assets.
Technical analysis is just one tool to keep in your toolbox. It’s not a cheat code that allows you to predict exactly what’s going to happen with stocks. This is why the best traders will layer other forms of research on top of their technical analysis – it helps provide as clear a picture as possible before trading.
This is a debate that rages on among investors. What’s best – technical analysis or fundamental analysis? The truth is, neither is definitively superior. Both can play an important role when you’re researching possible trades for stock or other assets.
In general, technical analysis can be more useful for figuring out shorter-term price movements. But, if you rely solely on technical analysis, you could miss an obvious warning signal. You could also miss a positive sign that you would have been aware of with just a small bit of fundamental analysis.
This type of investment research can have a narrow focus because it’s the small details that make a difference. It’s this attention to detail that makes technical analysis useful, but this strength can sometimes be its biggest weakness.
Here are some of the major drawbacks and limitations of using technical analysis for investing and trading:
Although it has its drawbacks, there are some very useful benefits for traders willing to put in the time and learn how to use technical analysis to their advantage:
The best way to get the most out of technical analysis is to make sure you don’t use these skills in isolation. If you’re able to combine this with other types of analysis, you’ll be able to build a clearer understanding of possible price movements.
Armed with information from different types of research, you’ll be able to make better decisions as a trader or as an investor. This will reduce the likelihood that you’ll make costly mistakes, and it can improve your chances of trading profitably.
One of the basic theories and methods you’ll come across towards the start of your learning around technical analysis will involve tracking a “moving average”.
A basic moving average crossover strategy means tracking 2 moving averages of a stock or asset’s price, the 50-day and the 200-day.
If the 50-day moving average goes above the 200-day, this highlights a general upward momentum and creates a signal to buy, sometimes known as a “golden cross”.
If the opposite happens and the 50-day moving average goes below the 200-day, this can be used as a signal to sell, gloomily referred to as a “death cross”.
Learning how to use technical analysis properly will greatly improve your ability as a trader. And, it can help you make more profitable decisions. However, this type of analysis isn’t a silver bullet and it doesn’t provide a guaranteed way to make money when trading stocks or other assets.
Technical analysis can be extremely useful to both traders and investors. If you really want to boost your investing skills, it’s best used in partnership with other methods of investment research.
All investing should be regarded as longer term. The value of your investments can go up and down, and you may get back less than you invest. Past performance is no guarantee of future results. If you’re not sure which investments are right for you, please seek out a financial adviser. Capital at risk.
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