Technical analysis is a trading discipline employed to evaluate investments and identify trading opportunities by analyzing statistical trends gathered from trading activity, such as price movement and volume. Unlike fundamental analysts, who attempt to evaluate a security's intrinsic value, technical analysts focus on patterns of price movements, trading signals and various other analytical charting tools to evaluate a security's strength or weakness.
Technical analysis was first introduced by Charles Dow and the Dow Theory in the late 1800s. Several noteworthy researchers including William P. Hamilton, Robert Rhea, Edson Gould and John Magee further contributed to Dow Theory concepts helping to form its basis. In modern day, technical analysis has evolved to included hundreds of patterns and signals developed through years of research.
Technical analysts believe past trading activity and price changes of a security can be valuable indicators of the security's future price movements. They may use technical analysis independent of other research efforts or in combination with some concepts of intrinsic value considerations but most often their convictions are based solely on the statistical charts of a security. The Market Technicians Association (MTA) is one of the most popular groups supporting technical analysts in their investments with the Chartered Market Technicians (CMT) designation a popular certification for many advanced technical analysts.
The Underlying Assumptions of Technical Analysis
Charles Dow released a series of editorials discussing technical analysis theory. His writings included two basic assumptions that have continued to form the framework for technical analysis trading.
The efficient market assumption essentially means the market price of a security at any given point in time accurately reflects all available information, and therefore represents the true fair value of the security. This assumption is based on the idea that the market price reflects the sum total knowledge of all market participants. While this assumption is generally believed to be true, it can be affected by news or announcements about a security that may have varied short-term or long-term influence on a security’s price.
The second basic assumption underlying technical analysis, the notion that price changes are not random, leads to the belief of technical analysts that market trends, both short-term and long-term, can be identified, enabling market traders to profit from investing based on trend analysis.
How Technical Analysis Is Used
Technical analysis attempts to forecast the price movement of virtually any tradable instrument that is generally subject to forces of supply and demand, including stocks, bonds, futures and currency pairs. In fact, some view technical analysis as simply the study of supply and demand forces as reflected in the market price movements of a security. Technical analysis most commonly applies to price changes, but some analysts track numbers other than just price, such as trading volume or open interest figures.
Across the industry there are hundreds of patterns and signals that have been developed by researchers to support technical analysis trading. Technical analysts have also developed numerous types of trading systems to help them forecast and trade on price movements. Some indicators are focused primarily on identifying the current market trend, including support and resistance areas, while others are focused on determining the strength of a trend and the likelihood of its continuation. Commonly used technical indicators and charting patterns include trendlines, channels, moving averages and momentum indicators.