Technical analysis is an alternative investing strategy to fundamental analysis and if used correctly can be especially effective.
Stock charts are like Swiss Army knives, they are super handy tools that can be used in a variety of ways. Not only do they tell a story of the stock, but they can also be used to make precise investment decisions. The style of using stock charts to make these investment decisions is known as technical analysis and is often viewed as the polar opposite of fundamental analysis. Whether using technical analysis or not, knowing how to read stock charts is extremely important to any investor.
What is Technical Analysis?
Where fundamental analysis looks at the stock’s financial statements, its competitors and markets, technical analysis uses various stock charts to determine if the company is invest-able, pin-pointing the best price and time to invest. A stock chart shows you the history of a stock’s price over time and comes in a variety of formats. There are a multitude of variables that you can control in the display of stock charts that are essential to the use of technical analysis including:
- Time: you can have stock charts that show minutes, days, weeks, months or even years worth of price history.
- Chart style: you can display the data as a line graph, mountain, graph, OHLC (Open-High-Low-Close), Candlesticks, and more.
- Scaling: the vertical axis can usually be adjusted between arithmetic and logarithmic scales. The arithmetic scale is what you would expect, showing the horizontal lines at even intervals of $5 or $10 dollars ($50 in the case of Google). The logarithmic scale give you a better visual of the percent change in stock price so that a stock that the distance between a price of $20 and $40 is the same distance as $40 to $80 (both of which are 100% returns).
- Volume: displays the amount of shares trading hands everyday usually as a bar graph.
- Moving Averages: are among the most popular and important tool available to newer investors because they are easy to use and understand. Also, moving averages are used as components in many other charts and analyses. By smoothing out data points and number series, moving averages make it easier to identify trends and tendencies.
- Trend lines: graphically display the unmistakable direction in which a stock is heading.
The key to technical analysis is the history of prices paid for a stock and the volume of shares traded. The security’s intrinsic value is of no concern to those who employ technical analysis as a trading method but rather rely on charts and other tools to identify patterns and trends that can suggest future activity. In other words, the only thing that matters is a security’s past trading data and what information this data can provide about where the security might move in the future. The field of technical analysis is based on three primary assumptions: price moves in trends, the market discounts everything, and history tends to repeat itself.
Technical analysis can be used on any security with historical trading data. Alternative investments such as Forex, fixed-income securities (think bonds), futures and commodities are all ripe for analysis of the technical sort as well. The common application, however, remains on traditional stocks. There are variety of pre-determined chart patterns that have been identified, labelled and used by those who employ the use of technical analysis for stock investing.
Types of Trading Patterns
Technical analysis investors attempt to identify charting patterns and trade the stock based on these pre-determined price movements. Here are some brief examples of the most popular trading patterns identified in technical analysis.
Double Bottom and Top: these formations are reversal patterns that most often identify medium term and long term trend changes.
Cup and Handle: this formation literally resembles it’s named a cup with a handle at the end. It is widely known thanks to the CANSLIM trading strategy popularized by William O’Neil.
Saucers: also known as “rounded bottoms” or “U-Shape” formation have the same look and feel to them as the Cup and Handle pattern, except they lack a handle and often have a wider base. They are more difficult to trade as finding a proper entry point can be tricky, however when spotted, they can yield large returns.
Head and Shoulders: this formation can be the most difficult to spot but is historically reliable. It is a reversal pattern most often formed over a period of months.