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Intro to Technical Analysis

Technical analysis may be able to help you determine the best time to buy a security you want to add to your portfolio or sell one you already own. This approach works for stocks, indexes, futures contracts, and any other investment product whose price is driven by supply and demand in the market in which it is traded.

Technical analysis is based on the principles that:

  • Market prices reflect all the factors that affect supply and demand, including political and economic events as well as investor sentiment
  • Prices will continue to rise or fall until those factors change although there may be unexpected short-term price fluctuations

Supporters of technical analysis believe that studying prices gives you a meaningful understanding of investment movements and trends and forms the basis for making market decisions.

This is a different approach to investment decision-making than fundamental analysis, which is based on evaluating a company's products and services, the effectiveness of its management, its sales and earnings record, and other information to determine its stock's potential.

What Technical Analysts Do

The job of a technical analyst is to identify market trends and try to predict price movements using one or more technical indicators. Indicators are created by plotting data points on top of or alongside a price chart for a particular market or security. The data points are derived from price or sales volume information for that market or security over a specific period of time. The indicators, which can range from quite simple to very complex, are all alike in one way. They are designed to establish recognizable visual patterns, with names like pennant, V formation, or double top, which make the potentially confusing price data easier to decipher.

While each indicator shows a specific pattern, studying just one may not give you a complete picture of the direction that an investment's price is likely to head. One reason is that an indicator may give false signals. For example, if prices seem to be moving in one direction and quickly return to an original trajectory, the faulty signal is known as a whipsaw.

In addition, different indicators measure different variables. For example, a stochastic oscillator is used to show changes in price, while William's %R helps predict trend reversals. Reviewing a combination of indicators can help provide a balanced and inclusive look at an investment's current and potential price movements and reduce the distraction of faulty signals.

Trend Lines

The principle that prices trend in one direction or another is a key component of technical analysis. In a trending market, prices continually rise to form an uptrend or continually fall to form a downtrend. However, within either an uptrend or a downtrend, prices can also move sideways, or fluctuate up and down, forming a trading market. The longer the trend lasts, the more reliable an indicator it becomes, and the more confident an analyst is likely to be that prices will continue along the same trajectory.

Since an investment's price fluctuates regularly, even when the trend direction seems clear, technical analysts typically identify a trend they expect the price to follow rather than pinpointing a specific dollar amount they expect for the investment.

An uptrend line has a positive slope, which means that prices go up over time from the left to the right. The line is formed by connecting the lowest price data points on the price chart to create what is known as a level of support. That support level identifies the lowest prices the security is expected to reach over the course of the trend before demand increases and the price begins to rise. If a price drops below the support level, it could be a signal that the trend will soon reverse.

A downtrend line has a negative slope, which means that prices fall from the left to the right. The line is formed by connecting the highest data points on the price chart to form a level of resistance. When an investment is trending down, the level of resistance represents the highest price it is expected to reach over the course of the trend before investors begin to sell and drive the price down. If resistance is broken, it could be a sign of an upcoming reversal and that prices may begin to rise.

Prices can also rise and fall within the zone created by the support, lower, resistance, or upper lines. Analysts identify prices that move in this way by saying they are trending within channel lines.

However, you have to remember that despite their best efforts, technical analysts would agree that it is always possible that prices may not move the way their indicators appear to point since investing is inherently unpredictable. Just like any investing strategy, it doesn't guarantee a profit or protect against losses. You'll still face all of the same risks of investing.