Technical analysis is the stuff dreams are made of. It’s based on the simple premise that if you can anticipate when the market is going to go up or down, you can make spectacular gains. The promise that good timing can send your portfolio to unprecedented heights has made many publishers of investment strategy courses very rich. But has it done the same for investors?
This article will help you understand what technical analysis is, how it’s different from fundamental analysis, provide definitions for key terms used in technical analysis, and provide an overview of a few common technical indicators.
What is technical analysis?
Technical analysis, which is sometimes referred to as “timing the market” is a method that traders use to analyze the stock market that is exclusively concerned with a security’s price movement. Technical analysts examine stock charts carefully, using a variety of techniques, to find patterns that may predict whether a stock is going to go up or down.
Unlike the other common stock-picking method, fundamental analysis, practitioners of technical analysis believe that the fundamentals of a business (i.e. news events, earnings, dividend yield, etc.) are already factored into the price of a stock, and that the money to be made is in the stock’s day-to-day or hour-to-hour price swings. Rather than looking to hold positions for a long period of time, they are looking at the momentum of a stock over a short period of time to predict what it will do next. In some cases, this may be price movement that’s taking place over a few hours.
This short time between trades is another difference between technical analysts and fundamental analysts. If you’re looking to buy a car, you may spend weeks, even months, doing research trying to figure out WHY one car costs $5,000 more than another. But when you go to the grocery store, you're not going to spend hours figuring out why the items you want to buy are priced the way they are. You assume that the items in the store are priced to what the market will bear at that point in time and you are only willing to commit so much time.
As it applies to stocks, the technical analyst is not concerned with why a stock is priced a certain way because they are not looking to make a long-term investment. They are only focused on where it might be going in the immediate hours or days.
In addition to price, technical analysis focuses on volume. If two baseball players are batting .300 (averaging three hits for every ten at-bats), would you find that statistic more credible for a player who had 10 at-bats or a player who had 200 at-bats? The one with 200, right? Why? Because the higher volume of at-bats creates a higher degree of statistical significance. It's the same with stock price movement. If a stock is trading higher on low volume, then it won't take much selling to cause the price to go down. But if a stock is trading higher and there is high volume, that is a good indicator that buyers are showing conviction in the direction a stock is moving.
What technical analysis is not
Technical analysis is not a definitive decision-making tool, like a calculator. If you enter 2 + 3 into a calculator you can trust that the answer you get is going to be 5 each and every time. But what happens with a stock can be influenced by human behavior, which is always unpredictable. There are some stocks that investors will continue to pour money into causing the price to increase even when every technical indicator would say that it should drop. Likewise, when a stock is under selling pressure, that momentum can continue to cause the stock price to drop for irrational reasons.
Technical analysis helps inform traders in the decision making process. It is a predictive tool based on statistics and probability. For example, let’s say I knew that 8 out of the next 10 people that walked into a building were going to be wearing a red shirt. If you were blindfolded and asked to guess what color the next person was wearing, you could say red and probability would be on your side. But is it a guarantee? Of course not. There’s still room for error. So it is with technical analysis.
Terms that every technical analyst must know
But first, let’s talk about some terms that you’ll hear when these strategies are explained.
Trend line means the direction a stock's price is moving. Remember, no stock in the history of the world has ever moved in one direction all of the time. With that in mind, when you look at a stock chart and see the stock reaching higher highs and higher lows, that is a positive trend, meaning the price is going up. Conversely, when a stock chart shows a stock reaching lower highs and lower lows, that is a negative trend, meaning the price is going down.
Understanding how a stock is trending is important to technical analysts because when you’re looking for profitable, short-term trades, you don’t want to fight a trend.
Moving average defines a mathematical result calculated by averaging data points over a period of time. On a stock chart, the moving average is a smooth line that is plotted over the day-to-day price changes to give a better view of the trend line. The reason why it’s called a moving average is that these averages are all time-specific, so each time new data is added, old data drops off and the average “moves”. As we look at different technical indicators there are two additional terms to understand:
Simple moving average (SMA)– this is right out of middle-school math. You take the mean of a set of values. In the case of a stock chart, the values that are averaged are the prices over a period of time. To calculate the simple moving average you add up the prices in the time frame and then divide by the number of prices in that set. So to calculate a 10-day SMA, you would add the closing price of a stock for the last 10 trading days and divide it by 10. For a standard moving average, all values are weighted equally.
Exponential moving average (EMA)– this is a weighted average that assigns more value (or weight) to the most recent data points. In this way, it is more responsive than the simple moving average, which is preferable for some traders. You'll also notice that the exponential moving average is a key variable for some of the indicators below. The calculation for EMA is not middle-school math. But the good news is that if you’re serious about technical trading, most charting packages do the calculation for you.
Support level means a point of maximum support by buyers. It is the point where the number of buyers is greater than the number of sellers. On a stock chart, it is the trough right before a stock’s price goes up. The stocks price generally won’t fall lower than that level because there are plenty of buyers who are willing to pay that price for the stock because they consider it a bargain. There can be multiple support levels on a chart.
Resistance level means a point of maximum resistance for sellers. It is the point where the number of sellers is greater than the number of buyers. On a stock chart, it is the peak right before a stock’s price goes down. Think of it as “full price” - not many traders are willing to pay full price for a stock when they know it will probably go on sale shortly. There can be multiple resistance levels on a chart.
Support and resistance levels help traders identify where they want to enter (buy) or exit (sell) a position.
Standard deviation – this is a statistic that measures the historical volatility of an investment. A large standard deviation means that there is a greater variance between its price and the mean, indicating a wider price range. Calculating the standard deviation requires finding the mean of all the data points, calculating the difference between each data point and the mean, squaring and then finding the mean of all those differences, and then taking the square root of that number. Most trading programs will calculate the standard deviation for you.
What are the best technical indicators for stocks?
There are many, many strategies that technical analysts use. Most successful technical analysts focus on one or two strategies that allow them the highest probability for success. While this article will not cover all of them, we’ll explain some of the most common. Before we begin to review the different strategies, it's important to remember that technical analysts use indicators overlayed on charts so they don’t have to do the calculations themselves or pore over tables of numbers. When these indicators are combined with a price chart, they act like a decoder ring, revealing trends that you might not otherwise see.
Moving Average Convergence Divergence (MACD)– MACD shows the relationship between two exponential moving averages. To calculate the MACD, a stock’s 26-day EMA is subtracted from its 12-day EMA. To create a buy-and-sell trigger, a third element, the stock’s 9-day EMA is plotted on top of the MACD. Once all three EMAs are plotted, traders can interpret the data using either crossovers (convergence), divergence, or through dramatic rises. Each is briefly explained below:
- Crossovers – this is when the MACD falls above or below the signal line. A move above the signal line is a sign that the price is likely to have upward momentum. A move below the signal line indicates that there is downward pressure on the stock’s price.
- Divergence – this is when the stock price and the MACD move in opposite directions (or diverge) from each other. For technical analysts, this usually signals the end of a trend.
- Dramatic Rise – as the name suggests, this is when the MACD rises dramatically, that is the shorter term moving average pulls away from the long-term one. This tells investors that the stock is overbought which can mean that a correction is likely.
Bollinger bands– these show expansion or contraction of prices over a period of time. To create a Bollinger band on a stock chart, a centerline is created using an exponential moving average. After that, price channels (or bands) are created by calculating one standard deviation above and one below the centerline. The upper and lower bands become your guides. If prices continually touch the upper band, it’s an indication that the stock is overbought. Conversely, prices that continually touch the lower band indicate that it may be oversold.
Relative strength index (RSI)– this is a simple calculation that measures the magnitude of recent price changes to track momentum that may indicate when stocks are overbought or oversold. The calculation of the relative strength index is as follows:
RSI = 100 - 100/(1 + RS)
RS (Relative Strength) = the average gain of up periods during the time frame being measured divided by the average loss of down periods during the time frame being measured. RSI is usually calculated over 14 trading days.
An RSI can range from 0 to 100. An RSI at or above 70 usually indicates an overbought condition. An RSI of 30 or below usually indicates an oversold condition.
Fibonacci retracements– these are technical indicators that help traders identify strategic points to make transactions, set target prices or assign stop losses. Fibonacci retracement levels are created by placing horizontal lines at areas where a price meets support or resistance at key Fibonacci levels before continuing in its original direction. These levels are created by plotting a trend line between a major peak and trough, then dividing the distance between the two by the following ratios (called Fibonacci ratios): 23.6%, 38.2%, 50%, 61% and 100%.
Fibonacci retracements are static prices that do not change, unlike moving averages. Because they are static, traders get prudent guidance that allows them to react to a price change.
Stochastic oscillators– these are momentum indicators that compare a stock's closing price to its range of prices during the time frame being measured. The premise behind stochastic oscillators is that closing prices will tend to reflect market trends. So if the market is trending positive, an individual stock will generally close near its daily high, and if the market is trending lower, a stock will close near its daily low. The oscillator is range bound, however, its sensitivity to market movements can be reduced by either adjusting the time period or by calculating a moving average of the result.
Although some of these indicators may seem very complex, practitioners of technical analysis can buy charting software that does all the calculations, meaning that all you have to do is understand how to interpret the data.
And by all means, if you’re going to bring technical indicators into your stock-picking strategy, don’t confuse yourself by using multiple indicators at one time. Find the ones that seem to work best for you and try to perfect those. You can always try more at other times.
The bottom line on technical analysis
The allure of technical analysis is that there are great gains that can be made if only you know how to accurately interpret the price movement of different stocks. But investors should take caution that they are not using technical analysis merely to support their own assumptions. In this way, it’s a lot like fundamental analysis. Both methods require investors to allow the facts to inform their trading.
Technical analysis is not for everyone, but if you are the kind of investor that has enough time, enough restraint, and enough trust in statistics, there can be a lot of satisfaction in accurately predicting price movements. However, as much as we would like to believe otherwise, nobody can predict the market with 100% certainty all the time. Human behavior gets in the way of even the most accurate technical predictions. Technical analysis allows traders to analyze price trends and make decisions that are in sync with their tolerance for risk.