Technical analysts do not attempt to measure a security's
intrinsic value, but instead use charts and other tools to identify patterns
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. 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.
The field of technical analysis is based on three
assumptions:
1. The market discounts everything.
2. Price moves in trends.
3. History tends to repeat itself.
1. The Market Discounts Everything
A major criticism of technical analysis is that it only
considers price movement, ignoring the fundamental factors of the company.
However, technical analysis assumes that, at any given time, a stock's price
reflects everything that has or could affect the company - including
fundamental factors. Technical analysts believe that the company's
fundamentals, along with broader economic factors and market psychology, are
all priced into the stock, removing the need to actually consider these factors
separately. This only leaves the analysis of price movement, which technical
theory views as a product of the supply and demand for a particular stock in
the market.
2. Price Moves in Trends
In technical analysis, price movements are believed to
follow trends. This means that after a trend has been established, the future
price movement is more likely to be in the same direction as the trend than to
be against it. Most technical trading strategies are based on this assumption.
3. History Tends To Repeat Itself
Another important idea in technical analysis is that history
tends to repeat itself, mainly in terms of price movement. The repetitive
nature of price movements is attributed to market psychology; in other words,
market participants tend to provide a consistent reaction to similar market
stimuli over time. Technical analysis uses chart patterns to analyze market
movements and understand trends. Although many of these charts have been used
for more than 100 years, they are still believed to be relevant because they
illustrate patterns in price movements that often repeat themselves.
Not Just for Stocks
Technical analysis can be used on any security with
historical trading data. This includes stocks, futures and commodities,
fixed-income securities, forex, etc. In this tutorial, we'll usually analyze
stocks in our examples, but keep in mind that these concepts can be applied to
any type of security. In fact, technical analysis is more frequently associated
with commodities and forex, where the participants are predominantly traders.
Now that you understand the philosophy behind technical
analysis, we'll get into explaining how it really works.
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