What is Technical Analysis?

There are two types of analysis when analyzing a stock to forecast direction, fundamental analysis and technical analysis. At the most basic level, a technical analyst approaches a security from the charts, while a fundamental analyst starts with the financial statements. Fundamental analysis involves analyzing the financial characteristics of a company in order to estimate its value. Technical analysis takes a completely different approach; it doesn’t care one bit about the “value” of a company. Technicians (sometimes called chartists) are only interested in the price movements in the market determined by trends and past movements. You might say a trader who only does technical analysis in probably a short term trader and a fundamental analyst is more for long term investments. However, most also include technical analysis. I am a technical analysis trader and I concentrate on 1 and 2 week options. However, I do look at the fundamentals when I feel I might hold a stock for some time to sell Covered Call options repeatedly.

Technical analysis is a method of evaluating securities by analyzing the charts and trend lines generated by market activity, such as past prices and volume. Technical analysts do not study the company’s financials to measure the intrinsic value, but instead use charts and other tools to identify patterns, trends and past movements that can suggest future activity.
Just as there are many investment styles on the fundamental side, there are also many different types of technical traders. Some rely on chart patterns, others use technical indicators and oscillators, and most use some combination of the two.

Indicators are statistics used to measure current conditions as well as to predict financial or economic trends. An oscillator is a technical analysis tool that is banded between two extreme values and built with the results from a trend indicator for discovering short-term overbought or oversold conditions. Overbought and oversold conditions is something a technical trader looks for in their charts. As the value of the oscillator approaches a very high extreme value, the asset is deemed to be overbought, and as it approaches the lower extreme, it is deemed to be oversold. A swing trader like myself will consider entering a  Short position when we see an overbought situation or a Long position in an oversold situation. In short, these conditions will define a stocks support and resistance.

In any case, technical analysts’ exclusive use of historical price and volume data is what separates them from their fundamental counterparts. Unlike fundamental analysts, technical analysts don’t care whether a stock is undervalued; the only thing that matters is a security’s past trading data and what information this data can provide about where the security might move in the future. Technical traders look for trends!

One of the most important concepts in technical analysis is that of the trend. The meaning in finance isn’t all that different from the general definition of the term so it doesn’t go into “The Strange Lingo of Options” like many other common terms. A trend is really nothing more than the general direction in which a security or market is headed.

Unfortunately, trends are not always easy to see. In other words, defining a trend goes well beyond the obvious. In any given chart, you will probably notice that prices do not tend to move in a straight line in any direction, but rather in a series of highs and lows. In technical analysis, it is the movement of the highs and lows that constitutes a trend. For example, an uptrend is classified as a series of higher highs and higher lows, while a downtrend is one of lower lows and lower highs

In this figure you will see an example of an uptrend. Point 2 in the chart is the first high, which is determined after the price falls from this point. Point 3 is the low that is established as the price falls from the high (2). For this to remain an uptrend, each successive low must not fall below the previous lowest point or the trend is deemed a reversal, meaning the start of a downtrend. As you can see, each high is a new high (2, 4, & 6). Also, each low is higher than the previous low. 3 is a higher low than 1, and 5 is a higher low than 3. This is a classic uptrend.

There are 3 types of trends, Uptrends, downtrends and sideways/horizontal trends. If you want to get really technical, you might even say that a sideways trend is actually not a trend on its own, but a lack of a well-defined trend in either direction. I believe there is such a thing as a sideways trend and I watch for them. In any case, the market can really only trend in these three ways: up, down or nowhere.

Once you understand the concept of a trend, the next major concept is that of support and resistance. Above I mentioned overbought and oversold. An overbought situation might be and area of resistance and an oversold situation you will hit support. You might hear technical analysts talk about the ongoing battle between the bulls and the bears, or the struggle between buyers (demand) and sellers (supply). This is revealed by the prices a security seldom moves above (resistance) or below (support).

These support and resistance levels are seen as important in terms of market psychology and supply and demand. Support and resistance levels are the levels at which a lot of traders are willing to buy the stock (in the case of a support) or sell it (in the case of resistance). When these trendlines are broken, the supply and demand and the psychology behind the stock’s movements is thought to have shifted, in which case new levels of support and resistance will likely be established.

As you can see in the figure above the dotted line is shown as a level of resistance that has prevented the price from heading higher on two previous occasions (Points 1 and 2). However, once the resistance is broken, the dotted line becomes a level of support (shown by Points 3 and 4) by propping up the price and preventing it from heading lower again. I must point out that I do not rely on this pattern alone. I also look at other indicators such as my Moving Average Lines to get additional confirmation of direction.

Also when it comes to Technical Analysis, in addition to my brief explanation above, I’ll be talking about Candlestick Charts, Candlestick Time Frames, Noise, Moving Average Lines and Chart patterns. There are many tools and ways to do technical analysis. I am only writing about the tools I use. To further your education you can google “Technical Analysis.”  All of my pages on the tools I use are located under Technical Analysis in the top menu bar which is the section you are now in.