Basics of Technical Analysis

(By Chip Anderson)

The Value of Technical Analysis

The reason technical analysis has value is that directional price moves are often sustained for a period of time allowing analysts to detect and profit from the change in price. Even though a technical analyst has many math-based tools to analyze price and volume movement, the process is ultimately an art in the study of human behavior.

Just as the meteorologist can never guarantee a weather forecast, a technical analyst can never be perfectly certain of future price movements since human behavior is involved.

Figuring out the what and when…

All investors are faced with three basic questions with their investments. What to invest in, when to buy and when to sell. Technical analysis provides a framework for investors to methodically select equities and pick times to buy and sell. Emotion, the investor’s nemesis, is greatly reduced in these decisions since the investor can develop a list of ‘what and when’ rules to follow. Rather than ‘buying and hoping for the best’, technical analysts always know how much risk they are taking and know when to ‘get out while the getting is good’.

Only price and volume only…

Only historical price and volume data is used for technical analysis. The underlying premise of technical analysis is that all known information such as what a company does, its financial results, analyst’s ratings, management performance, politics, news, etc. are reflected in the historical price and volume data. This is a powerful concept since it is impossible to gage how these factors may influence future price separately.

It is important to understand technical analysis can only be used to determine the likely direction of future prices. It cannot anticipate news events or how investors will respond to them.

The Goal of Technical Analysis

The graph above is a historical price chart for the company Analog Devices, Inc., ticker symbol ADI. The line represents the price of ADI over a period of a year. The price chart illustrates how prices can move up, down or sideways for months at a time. Technical analysis uses methodologies to help indicate when prices are beginning to change direction. The goal of a technical analyst is to buy an equity when the price chart indicates prices are beginning to move up and then sell when the price chart indicates prices are beginning to move sideways or down.

Why Technical Analysis Works

Technical analysis works because price and volume often reveal the collective psychology (the “fear/greed balance”) of a market’s participants. Technical charts can reveal changes in the fear/greed balance soon after those changes occur and that provides opportunities for profitable trades. Technical analysts work to identify charts where the fear/greed balance has recently changed in a predictable manner. They then place trades to try and profit from that change. Once they have bought a stock, technical analysts monitor price and volume for sell signals. Done correctly, trades based on technical analysis carry a higher than average chance of success but disciplined money management techniques must still be used to guard against unforeseen price movements.