Technical analysis: Using historical patterns and group behavior to predict future moves in stocks and other assets

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Technical analysis: Using historical patterns and group behavior to predict future moves in stocks and other assets
Technical analysts see the past as the the best indicator of future trends. Prasit photo/Getty
  • Technical analysis studies historical patterns and group behavior to predict future movements in asset prices.
  • Technical analysis is a strategy that's based on the idea that history repeats itself and asset prices reflect all relevant information.
  • Technical analysis has its limitations and can be used together with other methods.

When it comes to investing decisions, most people's initial thoughts center around a company's sales, earnings, or its balance sheet in order to assess its value. Choices based on events such as Apple's sales beating forecasts, OPEC cutting oil output, or Netflix's subscribers exceeding what Wall Street had expected are based on fundamental analysis.

Technical analysis takes a different approach. This discipline looks past fundamentals and the news of the day, focusing instead on historical prices and trading patterns to predict future trends. The idea is that all relevant market information is already reflected in the price of a security.

Charles Dow, creator of the Dow Jones Industrial Average and founder of the Wall Street Journal, introduced technical analysis to market watchers in the late 1800s through a regular column in the newspaper. His ideas on stock price patterns came to be known as Dow Theory, and they provide the foundation for much of the technical analysis that came later.

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How does technical analysis work?

Technical analysis can be applied to any security with historical data, from stocks to bonds, currencies to commodities, and anything in between. As long as there is past price information, there's an opportunity to use technical analysis. This is often done by charting the relevant data to generate short-term trading signals. Once charted, a technical analyst can interpret the information to make an informed trading decision.

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In technical analysis, past price behavior is considered the best way to forecast future prices. Indicators of various kinds are used to identify trends and determine the path of a security.

Technical analysis posits that all the relevant market information is reflected in the price, and that history is likely to repeat itself. This isn't thought to necessarily happen in the exact same way, but certainly in similar patterns. Of course, different analysts can have different interpretations of the same data.

"Visualizing the psychology of market participants allows technical analysts to see supply and demand levels to get an idea of how prices may move in the future," says Jake Wujastyk, chief market analyst at technical analysis software firm TrendSpider.

There are three core principles in technical analysis:

  • Market action discounts everything. A stock's price reflects everything that has or could affect a security.
  • Prices move in trends. This means that after a trend has been established, the future price movement is more likely to be in the same direction as the trend until a new trend is established.
  • History repeats itself. Prices are predictable because history repeats itself. By analyzing chart patterns, we can identify trends and forecast the future of a stock or the market as a whole.

Technical analysis is subjective, and different traders will often use divergent techniquest to evaluate the patterns seen in the same chart, says StockCharts.com's senior technical analyst Julius de Kempenaer.

How is technical analysis used?

Technical analysis: Using historical patterns and group behavior to predict future moves in stocks and other assets
Rachel Mendelson/Insider

Traders use technical analysis in many ways, but one of the basic concepts is support and resistance. Support is a price level where a security tends to stop falling. If a stock price dips below an area of support and remains there for a while, that's usually a sign it will continue to drop. Resistance is the level where a stock stops rising. If it breaks above that price and holds there, that's seen as an indication it will continue to rise.

Moving averages - the average price of a security over a set period of time - are frequently identified as support and resistance levels.

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Take the S&P 500, for example. With few exceptions, the index's 50-day moving average has proven to be a reliable support level in recent years. When the price of the S&P 500 rises above the 50-day moving average and keeps up that behavior, it's likely that the upward trend will continue. So savvy traders will buy when there is a momentary drop below that line.

What are the main technical indicators?

There are many indicators that a market technician can use to analyze a security. Some of the most common are:

  • Price trends: The general direction in which the price of a security is going. The trend is your friend, they say, and it points to what the future holds.
  • Moving averages: This takes the average of a security's price over a set amount of time, like 50, 100 or 200 days. The moving average shows the bigger picture.
  • Chart patterns: Take a chart and find a pattern and it will likely repeat itself.
  • Support and resistance levels: Think of these as a sort of band within which a security bounces. At the support level, the price regularly stops falling and bounces back. At the resistance level, the price generally peaks and dips back down.
  • Volume indicators: Volume indicators will show you the popularity of a stock or option. If a stock is dropping on little volume, it may not be as meaningful as if it's dropping a heavier-than-normal volume.
  • Momentum indicators: This shows where the price of a security is today versus a set number of days in the past. It can help determine how weak or strong a security's price is.
  • Oscillators: Oscillators are a type of momentum indicator. They show trends between high and low bounds, which traders use to determine if a security is overbought (overvalued) or oversold (undervalued).

    Limitations of technical analysis

    Technical analysis is not a crystal ball. Rather, it's a useful tool for helping define risk and determine market psychology, says Marc Lichtenfeld, chief income strategist at The Oxford Club, a private network of investors.

    Technical analysis could never have predicted the shocking market plunge driven by COVID-19 in March 2020. In fact, while one of the tenets of technical analysis is that all relevant information is reflected in the price of a security, there is an exception for unexpected news like natural disasters or acts of God. But, as StockCharts.com's de Kempenaer says, technical analysis "will definitely be of help to figure out when you should be getting back in."

Technical analysis vs. fundamental analysis

Where technical analysis is focused on charts and price patterns, fundamental analysis looks at financial statements, earnings, dividends, and other metrics.

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Fundamental analysts see price movements linked to all things related to the company - earnings, the actions of competitors, and news. Let's say Tesla gets an order from a rental-car company for 100,000 vehicles. That's positive news that will probably result in an increase in sales. Fundamental analysis would say the stock is likely to rise. Alternatively, let's say a Tesla randomly catches on fire or is involved in an accident while on autopilot. That's obviously negative news that will be seen as likely to lead to a decline in the shares.

In technical analysis, all of that is irrelevant. Long-term analyses of price changes indicate that such news events are short-term and limited. In fact, "Many times, technical analysts do not know what a company does, as they only care about the price action of the company's stock," says TrendSpider's Wujastyk.

StockCharts.com's de Kempenaer notes that technical analysis is based on actual facts, whereas with fundamental analysis almost always works with expectations - and the future is always uncertain.

The financial takeaway

Technical analysis has been around for more than a century, and many traders swear by it. You can log on and start analyzing charts right now, looking for patterns and trends. But like all strategies, technical analysis, while quick and efficient, has its limitations. Given the number of analysis methods, indicators and time frames possible, forming a single view can be a challenge.

While fundamental analysis tends to be better for long-term investing, technical analysis can be more useful in the short term. Ultimately, using a combination of both techniques might be the best way to come up with an informed determination of the value of a particular security.

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