Technical analysis trading is when investors attempt to predict future price trends by relying on historic data. They use statistics that reflect investor behavior such as prices, volume, open interest, moving averages and other trading variables to make investment decisions. These data are plotted onto charts.
This sort of investing is not suitable for beginning investors but it is important to know that this field of stock “study” exists.
Technical analysis is applied to the broader markets, single stocks or a group of stock such as pharmaceuticals. It ignores stock fundamentals and studies only the impact of previous stock movements on future trends, whereas fundamental analysis studies the causes that can affect a stock price.
There are a few basic principles behind technical analysis trading
- Pattern of price movements can be mathematically modeled onto charts. The probability is that an already identified price pattern will repeat itself.
- It is only concerned with the price and volume action in the market, not the reasons for the moves
- Investor behavior is predictable and trading psychology does not change – trading patterns identified decades ago are still valid today.
Trading Analysis indicators
The indicators used are either lagging or leading indicators. A typical lagging indicator is the MACD or moving average convergence divergence which shows the relationship between two moving averages of prices. If the MACD break above a signal line, it is a bullish indicator, and conversely, it may be time to sell if it falls below.
One of the more famous examples of technical analysis is the “sell in May and go away” investing strategy which looks at the fact that historically the stock market hasn’t done all that well between May and October (when you are supposed to buy again).
A commonly used leading indicator is the relative strength index (RSI) which measures the relative outperformance of a stock against another, or against a market index such as the S&P 500. Some technical analysts believe that the higher the relative performance, the more likely the uptrend will continue. Others believe a high RSI could mean an overbought stock, suggesting that it is about to fall.
Technical analysts also use numbers theories such as the Fibonacci sequence and the Elliot wave theory, the latter suggesting a stock trades on repetitive wave patterns.
As you can see, technical analysis is not necessarily cut-and-dry and various interpretations can be attached to the same set of indicators. I personally give no weight to technical analysis but I think it is important to understand the philosophy behind it.