What Is Technical Analysis & How Does It Work?

Technical analysis of the financial markets works on the basic theory that history repeats itself. Markets, indexes, and securities, even with their blips, tend to move in consistent patterns, and those patterns can be useful for predicting market moves. Most technical analysis looks at the historical length of a financial trend and the likelihood it will endure or reverse. 

Although the practice may sound high-tech, traders have been using various technical analysis methods to analyze the markets since the 18th century. It also offers an important counterpoint to fundamental analysis, which requires an intensive understanding of a specific company, an entire industry, and the health of the broader economy.

What is technical analysis?

Technical analysis is a method of analyzing stocks that studies historical market details and mines data from behavioral economics and quantitative analysis to predict the market’s direction in the future. The philosophy behind it is that market sentiment drives stock prices, influencing the way securities move in the short term and creating trends that can be analyzed for future use.

Stock market technical analysis is not foolproof: The past doesn’t always predict the future, particularly when unforeseen forces enter the picture (pandemics, natural disasters, wars). But with the advanced tools analysts and investors have at their disposal, technical analysis is becoming more useful and accessible.

Indicators in technical analysis

Those who use technical analysis rely on indicators, which are calculations plotted in a chart to help traders see market trends. Leading indicators are signals that predict future movements, and lagging indicators are financial signs that become clear after an event has taken place. The calculations are based on historic price, volume, momentum, and other patterns. Here are tools technical analysts use as indicators.

Price trends

Past prices are considered a good predictor of future prices. Price trends are among the most accessible indicators: Anyone can look at historical price data, peg it to events in the market, and recognize patterns. Fundamental analysts may use it in conjunction with their analysis to find price levels to trade.

Chart patterns

Technical analysis is known for its chart patterns, which are traced by changes in a security’s price. One of its important elements is known as a trend line, which shows a security’s overall trajectory. Traders pay particular attention to the time frame on the charts, which might range from one minute to as long as a year.

Volume and momentum indicators

Volume is the number of shares of a security that trade during a day. Looking at volume can help analysts and traders understand the strength of a trend. Momentum shows the speed of price changes and is another benchmark analysts use to measure market strength.

Momentum and volume indicators help analysts understand whether price movements represent a strong trend or whether a trend is winding down. Because the purpose of momentum indicators is not to measure market direction so much as it is to measure strength, analysts often pair them with other technical analysis indicators to develop a trading strategy.

Oscillators

A stochastic oscillator builds a trend indicator on a range of high and low prices over time. Traders use this tool to look for short-term overbought or oversold stocks. The former is a stock that is trading at a price above its intrinsic value, and the latter is trading below its value and expected to rise. When the value of the oscillator rises, technical analysts read the stock as overbought, and consider it oversold at the lower end.

Moving averages

The moving average is used to show the direction a price is trending, factoring out short-term price blips. The indicator creates a trend line by combining price points over a particular time frame and dividing by the number of data points. When the moving average is higher, the security is considered to be trending upward; conversely, a lower moving average indicates a falling value over that time period.  

Support and resistance levels

A security’s past lows and highs above or below the stock’s current price are seen as the respective support and resistance levels. These are significant indicators to analysts because support signifies a price point below the market price that indicates where demand is high enough to prevent a price from dropping even more.

Resistance is a price above the current market price that indicates selling interest, keeping the stock from moving higher. Analysts may consider a price drop below a recent support line to indicate a bearish trend. Conversely, when a security takes off above a recent resistance line, this could indicate a bullish trend.

Types of technical analysis

Technical analysts use two basic approaches:

Top-down

This involves looking at securities from a broad market standpoint and narrowing the focus to specific charts for securities. An analyst might begin by looking at daily moving averages and then focusing on hourly averages, moving from a major index to a sector chart, and then drilling all the way down to an hourly chart for a security.

Bottom-up

Bottom-up investing begins with the analysis of individual stocks and pays less initial attention to market cycles. The assumption is that if an individual company is strong, its securities will do well regardless of the market. Analysts will look at securities that are bucking market trends, and then search out trading points for those securities.

Advantages of technical analysis

Technical analysis doesn’t necessarily require deep understanding of a specific security or company and can be applied in a wide array of situations.

• Technical analysis, which is all about identifying patterns, is a visual pursuit. People who don’t consider themselves quants often find this way of presenting information easier to understand.
• The same analysis can be used for futures, commodities, stocks, currencies, and indexes.
• Those with different trading styles can use technical analysis. Each kind of investor—from day trader to buy-and-hold—can map patterns and identify trading opportunities.

Limitations of technical analysis

Technical analysis has a number of drawbacks, the most important of which is its heavy reliance on historical price patterns. But there are others.

• Although technical analysis is based on patterns and the assumption that they repeat, critics of the technique say that history doesn’t exactly repeat itself, which makes it a useless predictor.
• Where fundamental analysts have a deep knowledge of a company or industry within the context of the market, those who do technical analysis study only market trends and may lack context for a trade decision.
• Charts are only as good as a person’s ability to interpret them. Various patterns can be misread for any number of reasons.
  

Technical analysis vs. fundamental analysis

Securities analysts generally fall into two camps: those who study the fundamentals and those who do technical analysis.

Fundamental analysis focuses on the intrinsic value of a company’s stock: its business model, financial ratios, financial statements, company management, and so on, within the context of the overall market and economy.

Technical analysts don’t use company-provided information or public filings to make their determinations. Rather, they look at the patterns in the price and momentum of a stock’s movement. In technical analysis, the stock’s historical price is the driver. Technical analysts generally make short-term decisions and make no attempt to determine long-term valuation.

The bottom line

The idea behind technical analysis is that market psychology and trends drive prices—not the fundamental health of the company. Both individual investors and professional analysts can use technical analysis. It doesn’t require intensive research into a company’s inner workings, like fundamental analysis, and instead relies on knowledge of trends, historical prices, and investor psychology.