Technical Analysis Concept, Assumptions and Approaches

13/10/2022 0 By indiafreenotes

Technical analysis is a trading discipline employed to evaluate investments and identify trading opportunities by analyzing statistical trends gathered from trading activity, such as price movement and volume. Unlike fundamental analysis, which attempts to evaluate a security’s value based on business results such as sales and earnings, technical analysis focuses on the study of price and volume.

Technical analysis tools are used to scrutinize the ways supply and demand for a security will affect changes in price, volume, and implied volatility. It operates from the assumption that past trading activity and price changes of a security can be valuable indicators of the security’s future price movements when paired with appropriate investing or trading rules.

It is often used to generate short-term trading signals from various charting tools, but can also help improve the evaluation of a security’s strength or weakness relative to the broader market or one of its sectors. This information helps analysts improve their overall valuation estimate.

Assumptions of Technical Analysis

Price Discounts Everything

To predict the future stock price with past data, investors use two approaches, namely fundamental analysis, and technical analysis. Fundamental analysis studies the company’s financial statements along with micro and macro-economic data as well as the risk factor of the stock on the current market price in a given period. Conversely, the technical analysis considers only the price movement.

Technical analysts assume all investors are already aware of everything about a stock as anything that affects the price is considered beforehand by incorporating fundamental analysis.

Therefore, the only thing studied under technical analysis is the price movement that gets affected by the forces of demand and supply represented on charts.

Prices Follow a Given Trend

This assumption shows the price follows a past trend rather than moving unevenly. Each stock chart depicts its unique trend and the stock price moves within the trend. It shows which stock will trend in the pattern. When a trend gets established the stock price is assumed of moving in a particular pattern until a new trend is formed.

But in reality, there is some randomness dominating the stock price, as uncertainty surrounds the stock price movement because of the volatile nature of the market.

Patterns in Price Movement Often Repeat Themselves

The last assumption of technical analysis states that trends are repetitive, and both human behavior and human history repeats itself. As the stock price pattern is repetitive, technical analysts observe the past stock price to predict future price trends by using the chart patterns. The repetitive nature of the trends is a clear sign of the fixed market psychology.

The Advantages of Technical Analysis

  • Data for predicting the future stock price is easily available and reliable in the case of technical analysis. The technical data incorporates the economic indicators, therefore the analysts don’t wait for the monthly or quarterly report to observe and then act.
  • Technical analysis provides quick information as all the data gets available in one chart. In a fraction of seconds, the investor is able to recognize whether the trade is worth entering or not.
  • The profit target and risk management parameters can be easily assessed.

The Disadvantages of Technical Analysis

  • Technical analysis doesn’t take a deep drive in the ocean of the stock market and its trends. A deeper understanding gets ensured by fundamental analysis.
  • The technical analysis shows the short-term trends in stock price but fails to provide a long-term analysis of stock price trends. The long-term analysis is stated by fundamental analysis.

At last, the technical analysis is the apt tool for predicting future stock prices by using past trends for short-term trading in order to make quick money.

Approaches

Pick a Strategy or Develop a Trading System

The first step is to identify a strategy or develop a trading system. For example, a novice trader may decide to follow a moving average crossover strategy, where they will track two moving averages (50-day and 200-day) on a particular stock price movement.

For this strategy, if the short-term 50-day moving average goes above the long-term 200-day moving average, it indicates an upward price trend and generates a buy signal. The opposite is true for a sell signal.

Identify Securities

Not all stocks or securities will fit with the above strategy, which is ideal for highly liquid and volatile stocks instead of illiquid or stable stocks. Different stocks or contracts may also require different parameter choices in this case, different moving averages like a 15-day and 50-day moving average.

Find the Right Brokerage

Get the right trading account that supports the selected type of security (e.g., common stock, penny stock, futures, options, etc.). It should offer the required functionality for tracking and monitoring the selected technical indicators while keeping costs low to avoid eating into profits. For the above strategy, a basic account with moving averages on candlestick charts would work.

Track and Monitor Trades

Traders may require different levels of functionality depending on their strategy. For example, day traders will require a margin account that provides access to Level II quotes and market maker visibility. But for our example above, a basic account may be preferable as a lower-cost option.

Use Additional Software or Tools

There may be other features that are needed to maximize performance. Some traders may require mobile alerts or access to trading on the go, while others may leverage automated trading systems to execute trades on their behalf.