What Is Technical Analysis?

Technical analysis is a method of evaluating securities by analyzing the statistics generated by market activity, such as past prices and volume. 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.

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.

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.

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.

Technical analysis and fundamental analysis are the two main schools of thought in the financial markets. Technical analysis looks at the price movement of a security and uses this data to predict its future price movements. Fundamental analysis, on the other hand, looks at economic factors, known as fundamentals. Let's get into the details of how these two approaches differ, the criticisms against technical analysis and how technical and fundamental analysis can be used together to analyze securities.

The Use Of Trend
One of the most important concepts in technical analysis is that of trend. The meaning in finance isn't all that different from the general definition of the term - a trend is really nothing more than the general direction in which a security or market is headed.

There are three types of trend -
1- Uptrends
2- Downtrends
3- Sideways/Horizontal Trends
As the names imply, when each successive peak and trough is higher, it's referred to as an upward trend. If the peaks and troughs are getting lower, it's a downtrend. When there is little movement up or down in the peaks and troughs, it's a sideways or horizontal trend.

When analyzing trends, it is important that the chart is constructed to best reflect the type of trend being analyzed. To help identify long-term trends, weekly charts or daily charts spanning a five-year period are used by chartists to get a better idea of the long-term trend. Daily data charts are best used when analyzing both intermediate and short-term trends. It is also important to remember that the longer the trend, the more important it is; for example, a one-month trend is not as significant as a five-year trend.

Trendlines
A trendline is a simple charting technique tat adds a line to a chart to represent the trend in the market or a stock. Drawing a trendline is as simple as drawing a straight line that follows a general trend. These lines are used to clearly show the trend and are also used in the identification of trend reversals.

Channels
A channel, or channel lines, is the addition of two parallel trendlines that act as strong areas of support and resistance. The upper trendline connects a series of highs, while the lower trendline connects a series of lows. A channel can slope upward, downward or sideways but, regardless of the direction, the interpretation remains the same. Traders will expect a given security 2 trade b/w the two levels of support and resistance until it breaks beyond one of the levels, in which case traders can expect a sharp move in the direction of the break. Along wit clearly displaying d trend, channels are mainly used 2 illustrate imp areas of support and resistance.

Support And Resistance
The next major concept is that of support and resistance. You'll often 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).

Why Does it Happen?
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.

Round Numbers and Support and Resistance
One type of universal support and resistance that tends to be seen across a large number of securities is round numbers. Round numbers like 10, 20, 35, 50, 100 and 1,000 tend be important in support and resistance levels because they often represent the major psychological turning points at which many traders will make buy or sell decisions.
Buyers will often purchase large amounts of stock once the price starts to fall toward a major round number such as 50, which makes it more difficult for shares to fall below the level. On the other hand, sellers start to sell off a stock as it moves toward a round number peak, making it difficult to move past this upper level as well. It is the increased buying and selling pressure at these levels that makes them important points of support and resistance and, in many cases, major psychological points as well.

Role Reversal
Once a resistance or support level is broken, its role is reversed. If the price falls below a support level, that level will become resistance. If the price rises above a resistance level, it will often become support.

As the price moves past a level of support or resistance, it is thought that supply and demand has shifted, causing the breached level to reverse its role. For a true reversal to occur, however, it is important that the price make a strong move through either the support or resistance.Many traders who begin using technical analysis find this concept hard to believe and don't realize that this phenomenon occurs rather frequently, even with some of the most well-known companies.
In almost every case, a stock will have both a level of support and a level of resistance and will trade in this range as it bounces between these levels. This is most often seen when a stock is trading in a generally sideways manner as the price moves through successive peaks and troughs, testing resistance and support.

The Importance of Support and Resistance
Support and resistance analysis is an important part of trends bcoz it can be used 2 make trading decisions and identify when a trend is reversing. For Eg, if a trader identifies an important level of resistance tat has been tested several times but never broken, he or she may decide to take profits as the security moves toward this point because it is unlikely that it will move past this level.

Support and resistance levels both test and confirm trends and need to be monitored by anyone who uses technical analysis. As long as d price of d share remains b/w these levels of support and resistance, the trend is likely 2 continue. Itz important 2 note, however, tat a break beyond a level of support or resistance doesnt always have to be a reversal. For example, if prices moved above the resistance levels of an upward trending channel, the trend has accelerated, not reversed. This means that the price appreciation is expected to be faster than it was in the channel.

What is Volume?
Volume is simply the number of shares or contracts that trade over a given period of time, usually a day. The higher the volume, the more active the security. To determine the movement of the volume (up or down), chartists look at the volume bars that can usually be found at the bottom of any chart. Volume bars illustrate how many shares have traded per period and show trends in the same way that prices do.

What is Volume and why Volume is Important?
Volume is an important aspect of technical analysis because it is used to confirm trends and chart patterns. Any price movement up or down with relatively high volume is seen as a stronger, more relevant move than a similar move with weak volume. Therefore, if you are looking at a large price movement, you should also examine the volume to see whether it tells the same story.

Say, for example, that a stock jumps 5% in one trading day after being in a long downtrend. Is this a sign of a trend reversal? This is where volume helps traders. If volume is high during the day relative to the average daily volume, it is a sign that the reversal is probably for real. On the other hand, if the volume is below average, there may not be enough conviction to support a true trend reversal.

Volume should move with the trend. If prices are moving in an upward trend, volume should increase (and vice versa). If the previous relationship between volume and price movements starts to deteriorate, it is usually a sign of weakness in the trend. For example, if the stock is in an uptrend but the up trading days are marked with lower volume, it is a sign that the trend is starting to lose its legs and may soon end.

Volume and Chart Patterns
The other use of volume is to confirm chart patterns. Patterns such as head and shoulders, triangles, flags and other price patterns can be confirmed with volume, a process which we'll describe in more detail later in this tutorial. In most chart patterns, there are several pivotal points that are vital to what the chart is able to convey to chartists. Basically, if the volume is not there to confirm the pivotal moments of a chart pattern, the quality of the signal formed by the pattern is weakened.

Source - Investopedia.com