In a previous blog post, we covered the basics on fundamental analysis. But what about the other main mode of market analysis- technical analysis? Read on to find out more.
What is technical analysis?
Technical analysis is a method of market analysis that examines and predicts using historical data from price charts and market statistics, mainly prices and volumes. It is based on the idea that if a trader can identify previous market patterns, they can form a fairly accurate prediction of future price trajectories. Technical analysts operate under the belief that past trading activity and price changes of a security can be valuable indicators of the security’s future price movements.
It is one of the two major schools of market analysis, with the other being fundamental analysis. Whereas fundamental analysis focuses on the intrinsic value of an asset, considering external factors, technical analysis is based purely on the price charts of an asset. As mentioned above, you can find out more about fundamental analysis at our blog post here.
Why is technical analysis important?
Technical analysis can be a valuable tool for risk management, which is one of the most important parts of an effective trading strategy; once a trader understands the basic principles and concepts, it can be applied to any market, making it a flexible analytical tool. Where fundamental analysis looks to identify intrinsic value in a market, taking into consideration a number of external factors, technical analysis looks to identify trends with market data alone, making it less intensive.
While fundamental analysis allows you to determine the value of an asset over longer periods of time, and has more utility for trading operations that take place over these longer periods of time, technical analysis allows traders to effectively identify patterns and make informed predictions, and works well for short-term trading.
However, typically technical analysis works best when supported by fundamental analysis, and vice-versa, with most traders using an appropriate combination of both techniques to make informed trading decisions.
Types of technical analysis
There are a number of tools you can use in technical analysis, but the process itself can generally be sorted into two methods- top-down and bottom-up analysis. As a general rule, short-term traders will take a top-down approach and long-term investors will take a bottom-up approach.
Top-down analysis takes a broader view of the economy, looking at the overall economy before focusing on individual securities. For example, a stock trader would first focus on economies, then sectors, and then companies. This approach prioritises short-term gains rather than long-term valuations.
On the other hand, bottom-up analysis focuses on individual stocks as opposed to a macroeconomic view, analysing a stock that appears fundamentally interesting for potential entry and exit points. Traders who use bottom-up analysis intend to hold long-term views on their trades, seeking value in their decisions.
In addition to these two methods, different traders might analyse price charts along different axes. Day traders might use volume indicators and simple trendlines to inform their trading decisions, while swing or position traders may prefer technical indicators and chart patterns.
Pros and cons
While technical analysis is important, it is not all-encompassing or applicable to any trading situation. With this in mind, here are some pros and cons to consider before you start using it to inform your trades.
Pros:
- Technical analysis works well for quick decisions and short-term trading, and can be used to earn money quickly
- Technical analysis does not require as much research as fundamental analysis, as you are only analysing price charts
- The tools involved are so commonly used that many believe they have created self-fulfilling trading rules; as more and more traders use the same indicators to find support and resistance levels, there will be more buyers and sellers congregated around the same price points, and the patterns will inevitably be repeated
Cons:
- There will always be an element of market behaviour that is unpredictable. Although historical price patterns give us an insight into an asset’s likely price trajectory, that is no promise of success.
- Technical analysis does not give as comprehensive a view of global markets as fundamental analysis, which could make your trading operations more vulnerable to unanticipated financial consequences from significant social or economic upheavals affecting the value of a given asset