The Benefits of Technical Analysis
Gain some insight into where the stock price might be heading
Technical analysis involves visually displaying a stock's price history on a chart and analyzing the historical price movements. This analysis gives the stock trader some insight into the possible future stock price movements. The modern day concepts of technical analysis were developed during the late 1800s and early 1900s.
The concept behind trends within trends (such as a short-term within a medium-term trend) is accredited to Ralph Elliott developed the Elliott Wave Theory. The work done by Elliott paved the way to Understanding Trends.
Beginners wonder what is the difference between technical analysis and fundamental analysis and why are there two approaches to analyzing a stock. To put it simply, technical analysis is the process of analyzing a stock's price behavior while fundamental analysis is the process of evaluating the valuation and future prospects of the company. Thus there are two prices for a stock, fundamental analysis will determine what the company is worth and technical analysis tracks what the market is willing to pay for this stock.
While technical analysis is primarily directed towards short-term analysis and thus is extremely popular with stock traders, there are several concepts in technical analysis that are quite useful for a stock investor to understand. A lot of professional stock investors utilize some of these concepts to select a more opportunistic entry for their investments and indeed incorporate some stock trading in amongst their investments to further boost their returns.
One of the most useful concepts in technical analysis is that the historical pricing displayed on a stock chart clearly shows how stock investors have perceived this company in the past, whether this behavior is rational or not. When combined with some fundamental valuation techniques, it allows the stock investor to rationally determine whether a proposed investment has any realistic short-term gains left in it or whether there is a high probably that the stocks price may have already reached its peak and thus primed for a significant price correction.
Ultimately all stock price movement is governed by the supply and demand for those stocks. When the demand exceeds supply, stock prices are driven higher irrespectively of whether they should and this is reflected on a price chart.
This leads to a commonly observed issue. Financial news events that rationally should drive the stock's price in a particular direction often move in the opposite direction to what the financial news event would indicate.
Contrary to popular belief amongst beginner stock traders and investors, technical analysis was never intended to predict the future but rather to analysis the past so as to provide a probability as to the possible future outcomes. Thus, technical analysis provides the likelihood that price will move in a particular direction, it is not a certainty. This leads to the fact that not all trades taken end up being profitable and as such there are trades that lose money. An important concept in short-term trading is that losing trades should be exited at predetermined price levels in order to stop a small loss from becoming a big loss. This is something that beginner stock traders and short-term investors need to accept.
Professional stock investors use the 'probability of the possible future outcomes' to determine whether buying a stock at that point in time would be a wise decision or not. Should a trade be taken which subsequently moves against them and results in a loss, they then exit that trade at a predetermined price level, known as a Stop-loss.
Technical analysis is often criticized by stock investors' which largely revolves around the misguided notion of predicting the future. To a certain extent this is justified, but to dismiss it totally is a mistake. Historical stock price analysis provides valuable insight into the rational or otherwise behavior of stock investors and may well determine whether a fundamentally sound company is worth investing in at the current stock price.
There are three main categories in technical analysis:
Main categories in technical analysis:
- Charting: Displaying a company's share price history on a chart provides a method of visually observing how stock investors perceive this company. The most commonly used chart styles by stock investors and traders are the Line Chart and the Bar Chart. Also some stock traders prefer to use candlestick charts. Although there are several other chart styles, they are not as widely used.
- Chart Patterns: There are several stock pricing characteristics known as chart patterns that tend to show up on stock price charts. These chart patterns provide some insight into how stock investors perceive this stock and are commonly used as entry points by short-term trades.
- Chart Indicators: These are numerical calculations performed on the stock's price data by the charting software. The graphs produced are plotted on the stock chart. The purpose of these chart indicators is to provide some insight as to where the stock's price may be heading.
Stock Analysis for Finance Students and Investors