What Is Technical Analysis In Finance

Table of Content

Technical Analysis Definition

Technical analysis is the study of historical market data, including price and volume. Using insights from market psychology, behavioral economics, and quantitative analysis, technical analysts aim to use past performance to predict future market behavior.


What Does Technical Analysis Tell You?

Technical analysis is a blanket term for a variety of strategies that depend on interpretation of price action in a stock. Most technical analysis is focused on determining whether or not a current trend will continue and, if not, when it will reverse.

Most technical analysts use some combination of tools to recognize potential entry and exit points for trades.


A Brief History of Technical Analysis

The technical analysis of stocks and trends has been used for hundreds of years. In Europe, Joseph de la Vega adopted early technical analysis techniques to predict Dutch markets in the 17th century.

In its modern form, however, technical analysis owes heavily to Charles Dow, William P. Hamilton, Robert Rhea, Edson Gould, and many others.

These people represented a new perspective on the market as a tide that is best measured in highs and lows on a chart rather than by the particulars of the underlying company.

The diverse collection of theories from early technical analysts were brought together and formalized in 1948 with the publishing of Technical Analysis of Stock Trends by Robert D. Edwards and John Magee.

Candlestick patterns date back to Japanese merchants eager to detect trading patterns for their rice harvests. Studying these ancient patterns became popular in the 1990s in the U.S. with the advent of internet day trading.

Investors analyzed historical stock charts eager to discover new patterns for use when recommending trades.


How to Use Technical Analysis

The core principle underlying technical analysis is that the market price reflects all available information that could impact a market. As a result, there’s no need to look at economic, fundamental, or new developments since they’re already priced into a given security.

Technical analysts generally believe that prices move in trends and history tends to repeat itself when it comes to the market’s overall psychology.

Technical traders usually use a combination of the following technical analysis methods:

  • Chart Patterns Analysis.
  • Technical Indicators Analysis.
  • Depth Of Market (DOM) & Order Book Analysis.
  • Footprint Charts Analysis.

Chart Patterns Analysis is a subjective form of technical analysis where technicians attempt to identify areas of support and resistance on a chart by looking at specific patterns. These patterns, underpinned by psychological factors, are designed to predict where prices are headed, following a breakout or breakdown from a specific price point and time.

Technical Indicators Analysis is a statistical form of technical analysis where technicians apply various mathematical formulas to prices and volumes. Many trading systems are based on technical indicators since they can be quantitatively calculated.

Depth Of Market (DOM) & Order Book Analysis is a popular form of analysis that relies on studying the order book of the underlying asset to determine its short-term direction. Special programs and web tools are required for this type of analysis. It is usually popular among day traders and scalpers.

Footprint Charts Analysis is a type of candlestick chart that provides additional information, such as trade volume and order flow, in addition to price. It is multi-dimensional in nature, and can provide an investor with more information for analysis, beyond just the security’s price.


The Difference Between Technical Analysis and Fundamental Analysis

Fundamental analysis and technical analysis are the two big factions in finance.

Whereas technical analysts believe the best approach is to follow the trend as it forms through market action, fundamental analysts believe the market often overlooks value. Fundamental analysts will ignore chart trends in favor of digging through the balance sheet and the market profile of a company in search of intrinsic value not currently reflected in the price.

There are many examples of successful investors using fundamental or technical analysis to guide their trading and even those who incorporate elements of both. On the whole, however, technical analysis lends itself to a faster investing pace, whereas fundamental analysis generally has a longer decision timeline and holding period by virtue of the time required for the extra due diligence.


Limitations of Technical Analysis

Technical analysis has the same limitation of any strategy based on particular trade triggers. In a few words, the chart can be misinterpreted. Analyzing the past data only gives an edge in terms of probability – there are no certainties when it comes to the financial market.


Summary

  • Technical analysis attempts to predict future price movements, providing traders with the information needed to make a profit.
  • Traders apply technical analysis tools to charts in order to identify entry and exit points for potential trades.
  • An underlying assumption of technical analysis is that the market has processed all available information and that it is reflected in the price chart.