Intro to Technical Analysis: Part 1
January 27, 2016
Our #voleoTSX Ambassador, Mike Nesselbeck, explains the basics of technical analysis and how it can be used by investors to trade in the stock market.
First of all, what is technical analysis? Technical analysis is a stock valuation method using market activity by analyzing charts such as using past price and volume. Using charts, there are different tools to identify patterns and momentums to predict future activity of a security or index.
The goal of a technical analysis is to buy a security when the price chart indicates prices are beginning to shift up, and sell when the chart indicates prices arebeginning to decline.
Major assumptions in Technical Analysis:
1. Supply and demand predict stock prices:
A key assumption is that supply and demand drive stock prices with buying and selling volume. This supply and demand is driven by the market participant’s greed and fear, also called market psychology. Changes in trends can show changes in the levels of fear and greed by traders and investors.
2. History repeats itself:
Chart patterns tend to repeat themselves. Traders who follow this assumption also need to be careful because history may tend to repeat itself, but in ways that are not predictable. If you look at pricing bubbles, not everyone can predict a bubble because they tend to happen in different sectors at different times; but they still happen.
3. Stock prices move in trends:
After certain trend in a stock chart is established, future stock prices will generally hold near that trend in the same direction. A break in the trend may show a shift in the securities price for a certain time period (more info on trends in future posts).
4. A stock price reflects everything that has or will affect the underlying company (this includes fundamental factors)::
This means that the news release you read about a company released yesterday has already been incorporated into the company’s stock price. For technicians, this removes the need to consider individual factors separately.
How is technical analysis different from fundamental analysis?
The main difference is that fundamental analysis will value a stock by valuing the company as a whole, including intrinsic value. Fundamental analysts also looks into the securities balance sheets, income statements, and cash flow statements to make future predictions of the value of the company. While a technical analyst sees all the company’s value reflected in the stock price and chart data, eliminating the need to delve into the financial statements. Future price predictions are based on patterns in charts and ability to hold past trends in technical analysis. While fundamental analyst’s looks into growth on aspects of the financial statements to derive a future price prediction.
Trading or Investing?
Many fundamental analyst’s use a time horizon that is considered a long period such as six months to several years. This type of valuations may be better for investing as it takes a while for fundamental predictions to take place in the market, As well, changes in earning per share (a key fundamental analysis indicator) do not change every day, and are only presented quarterly. Additionally, the development of a new product may take twelve months to surface and generate profits in a company, which would impact the value of the company. Many technicians trade securities instead of long term investing, because the changes in price and volume, as well as other indicators change daily, which may change how the technician will view the stock. From day trading to holding positions for a few months is the general time horizon for technical trading strategies. This much shorter time horizon for viewing data for technical analysts can end with more trades of securities, and less long term investments.
Things to remember
Although technical analysis has some advantages over fundamental analysis, and vice versa, remember to stick to your trading strategy. Your strategy will only be as good as you are disciplined with following it. The market is never predictable, and technical analysis is not a system that can eliminate risk. It takes time and effort to learn a new trading system, be patient!
Stay informed for other parts of this technical analysis series.