Different kinds of investors use different kinds of methods to analyze stocks. Some choose studying the fundamental aspects of a stock. Such aspects include revenue, industry trends, and valuation. However, fundamental factors do not always show themselves in the market price. This is one of the reasons why other traders choose to learn technical analysis over fundamental analysis.
Still, many traders try to use both technical and fundamental analyses to come up with better trading decisions.
Let’s learn the basics of technical analysis and see how we can use it to our advantage.
What is Technical Analysis?
Technical analysis is a way to evaluate stocks. To do it, you need to perform statistical analysis of the market.
Contrary to fundamental analysts, technical analysts do not try to find a stock’s intrinsic value. instead, they try to hunt for patterns and trends. To do that, they use different tools and indicators. Once they find a pattern or a trend, they use it as the basis of their decisions.
The Right Approach
Basically, there are two approaches you can use in learning technical analysis.
The first one is the top-down approach. When you use the top-down approach, you try to find stocks that fit your technical criteria. For instance, you might want to invest in stocks that have broken out of their 50-day moving average.
The other one is the bottom-up approach. The bottom-up approach requires you to find fundamentally interesting for entry and exit points. For instance, you may want to find an undervalued stock in a downtrend. Once you find it, you use technical analysis to find a certain entry point when the stock could be bottoming out.
Aside from those two, remember that you can use different technical analysis forms. Depending on the kind of trader you are, you can choose a variety of tools for your goals.
Day traders, for instance, typically use trendlines and volume indicators to help them make a decision. Position or swing traders may gravitate towards technical indicators or chart patterns.
Before You Learn Technical Analysis, Remember these things
There are only five basic steps to start to learn technical analysis.
- Choose a technical analysis strategy or start developing your trading system.
- Spot tradable securities where you can use the strategy.
- Hunt for the right brokerage account for the execution of the trades.
- Identify an interface where you can track and follow your trades.
- Find any other applications you need for the implementation of the strategy.
Let’s dissect each of these steps in detail.
Step 1: Choosing a technical analysis strategy or developing your trading system
You can’t start to learn technical analysis without knowing which strategy to use. For instance, you may want to follow a moving average crossover. In this strategy, you will monitor two moving averages like 50-day and 200-day moving averages.
If the shorter term 50-day moving average soars above the 200-day moving average, it means there’s an imminent uptrend in price. You can consider this as your buy signal.
Step 2: Spotting tradable securities
Remember that a strategy may work well for one security but fail in another. This means that you should understand how securities behave and which strategy will fit which security.
Step 3: Hunting for the right brokerage account
After you choose a strategy and a security, your next step is to find a brokerage account. This brokerage account should support your selected type of security, such as penny stocks, common stocks, and futures.
The account should provide you the necessary functions for tracking and following your trading indicators. It should also keep the costs low, or the fees will eat away at your profits.
Step 4: Identifying an interface
Different traders have different needs in terms of functionality based on their strategies. For one, day traders typically need a margin account to access level 2 quotes. It also helps them gain access to market maker visibility.
Step 5: Finding any other applications
There may be other kinds of tools and applications you need to maximize your trades’ performance. Some people dash around due to different reasons so they need on-the-go trading tools. Others need automated trading systems in executing trades on their behalf.
Learn Technical Analysis: The Basic Assumptions
When you start to learn technical analysis, you’ll discover that technical analysts have three basic assumptions:
- The market doesn’t reflect everything
- Prices follow a trend
- History repeats itself
Let’s dig into each of these assumptions.
The market doesn’t reflect everything
According to other experts, technical analysis can be problematic because it doesn’t consider fundamental factors. It only pays attention to price movements.
On the other hand, technical analysts believe in the efficient market hypothesis (EMH). The EMH tells us that the market efficiently price each and every factor that can affect a company. Thus, there’s no need to find a stock‘s intrinsic value.
Therefore, technical analysts point out that there’s no need to consider each fundamental factor separately.
Prices follow a trend
This is one of the most obvious assumptions of technical analysis. Traders who use technical analysis believe that prices follow short, medium, and long term trends. Simply put, the stock’s price will typically follow a trend than fluctuate erratically. A huge number of technical analysis-based strategies have this as their central assumption.
History repeats itself
Technical analysts believe that everything has happened before, even those apparently new trends in the market. Trends and patterns are repetitive because of market psychology, which can be very predictable. Investors who use technical analysis also use chart patterns to analyze movements to understand trends.
Even if a lot of technical analysis forms have been use for more than 100 years, they are still relevant. This is because they illustrate price movements that, as a rule, repeat themselves.
Technical vs. Fundamental Analysis
Put simply, technical analysis concerns itself with the prediction of future price movements based on patterns and charts. Meanwhile, fundamental analysis concerns itself with the economic and financial factors that can influence a business.
Tools of Trading
We can clearly see the major difference between technical and fundamental analysis through the tools used by the analysts.
As we have mentioned, technical analysts start with charts and patterns. Fundamental analysts, on the other hand, use a company’s financial statements. They look at the company’s income statement, cash flow statement, and balance sheet.
Determining a Good Asset
A fundamental analyst’s goal is to determine a company’s stock’s intrinsic value. If the stock’s current market value is lower than the estimated intrinsic value, he or she sees that stock as a good investment.
Meanwhile, technical analysts propose that looking at a company’s financial statement is unnecessary. This is because the stock price already reflects all relevant information. The technical analyst instead focuses on the stock chart to find clues as to the price’s direction.
Technical analysts generally have a shorter term approach compared with fundamental analysts. Technical investors look at charts limited in weeks, days, or minutes. Fundamental investors, on the flip side, look at data over numerous quarters or years.
Simply put, fundamental investors wait for a long time before the intrinsic value manifests in the market.
Trading vs. Investing
Generally, a technical analyst tries to profit from multiple short to medium trade. For a fundamental analyst, it’s more important to make long term investments in the underlying business of the stock.
Technical Analysis vs. the Efficient Market Hypothesis
As we have indicated above, technical analysis also has its fair share of criticisms.
As many investors pointed out, technical analysis may just be a form of wishful thinking. Even so, many huge and reputable brokerage brands employ technical analysis. This is true even if Wall Street analysts mostly focus on the fundamentals of a business.
The efficient market hypothesis, meanwhile, negates both fundamental and technical analysis via its “strong form hypothesis.” Books like a “Random Walk Down Wall Street” details how this thinking works. Basically, it states that investors are better at guessing than picking appropriate stocks.
However, keep in mind that the efficient market hypothesis remains just a hypothesis. You as an investor or trader should know better which approach works for you.
Why not Use Both?
Many experts, meanwhile, agree that we can use both fundamental and technical analysis. Combining the functions of both schools of thought has proven to be very beneficial for traders and investors.
For instance, an investor may fundamentally analyze an undervalued stock and use technical tools for find specific entry/exit points for the position. This combination works better for severely oversold positions.
For another example, some technical traders look at fundamentals to back their trades up. A trader may be searching for a breakout ahead of an earnings report. Then, he will look at fundamentals see if the stock can potentially beat earnings.
Still, bear in mind that understand both approaches in-depth is crucial if you want to use them in tandem.
Overall, technical analysis is a very profound approach. However, it also has its difficulties and quirks. The bottom line is that you should know how to properly use it—and any other kind of approach for that matter.
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