What is technical analysis in the stock market

Technical analysis is a method of studying the dynamics of quotations in the past, on the basis of which a forecast of future price movements is made.

All figures and formulas of technical analysis are based on three sources of information:

  • Prices.
  • Trading volumes.
  • Time.

All its tools can be applied to different time intervals: from five minutes to a year. But it is not necessary to count on the fact that it will be possible to predict the price for a long period of time. Signals tell us where the trend is heading. But they do not guarantee that the growth they predict will be long enough to satisfy a long-term investor.

That is why technical analysis is widely used mainly by traders who do not work long term. Standard deal duration is no more than two to four weeks. Many people generally prefer intraday strategies. With the help of different tools, they are looking for local minimums and maximums. These short-term fluctuations do not depend on the fundamental factors and cannot be predicted on the basis of classical approaches of long-term investors.

Charles Dow was the founder of technical analysis. He first introduced his ideas to the public at the end of the 19th century. However, he did not systematize his works, and books on this method were published only by his followers. The most famous of them is Technical Analysis of Futures Markets. Theory and Practice” by John Murphy.

More than one hundred years have passed since the method was invented. During this time it has become clear that although technical analysis works, it is not without errors. Critics of this approach claim that reliable forecasts obtained are so-called self-fulfilling prophecies. Many traders simultaneously receive a signal that the price will go up, buy an asset and thereby push the quotations.

But many traders continue to value technical analysis for the following benefits:

  • Versatility. It is enough to understand the principles once and you can predict the price movement on any market.
  • Ease of learning. Basic tools are available in every trading terminal or online service.
  • The possibility of personalization. An experienced trader may not use basic settings and create their own.
  • Elements of discipline. The deal is opened only after a clear signal. There is no room for emotions, which is very useful for beginners.

Is technical analysis necessary for the long-term investor?

The extent to which you need technical analysis depends on the strategy you choose. It’s one thing if you send a fixed amount to your account twice a month on payday and payday and buy a certain set of stocks. It’s quite another if you invest once every quarter or six months.

I use purely fundamental analysis 95% of the time. The only reason I open or build up positions is my confidence in the long-term outlook of a stock. But some of the technical analysis tools that I find useful for my strategy belong to the simplest basic set:

  • support levels;
  • resistance levels;
  • trend lines.

An example of this pattern on the chart. The blue line represents a downtrend. It passes through several local highs, each of which was lower than the previous one. The red line is the nearest resistance. It will be possible to talk about a trend reversal only after the chart rises higher. The green line is the support level. Upon breaking it, the price is likely to move down sharply due to traders’ opening short positions and triggering stop-loss orders, rather than due to fundamental factors.

For example, I have decided that the price of some company has fallen below a fair price and I believe it is a good moment to buy on a drawdown. In this case, I will assess the situation from the point of view of technical analysis. If I see that the quotes have broken through a strong support level, I will postpone the purchase and observe the situation.

Of course, if we are talking about a horizon of 20-30 years, there is not much difference – to buy 3-5% more expensive or cheaper. But if you have a 5-7 year horizon, being able to find a local low can be helpful.

I believe that an investor should not put technical analysis ahead of fundamental analysis. If I find the entry point optimal from a long-term perspective, I will buy the stock even if there is no clear signal to open a long trade.

To summarize

Technical analysis of stocks can be useful at the time of making a decision to enter a position. However, it only works on liquid securities and not during periods of global market turmoil. As a long-term investor, I consider these tools to be auxiliary.

Tell me in the comments: do you use technical analysis methods before you buy a stock for the long term?

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