There seem to be two different schools of thought when it comes to using technical analysis to trade or invest in stocks. Those on one side see it as a vital and necessary tool needed for finding potential candidates, optimizing entry points, managing positions, and knowing when to exit. Those on the other side, who only use fundamental analysis, see technical analysis as something akin to voodoo.
But in reality, technical analysis is nothing more than the study of price and volume -- the two most important factors in the stock market -- and learning how to use it correctly can give you an advantage; one that will translate to a better bottom line for your overall P&L.
What is Technical Analysis?
There are a lot of different definitions of technical analysis, some good, and some bad, but for our purposes we will define it as “the graphic representation of investor sentiment.” That sentiment is represented by volume, the amount of shares a stock trades in a given time period, and price.
By plotting price and volume on a chart you can begin to get a picture of where investor sentiment has been, and where it may be going. There are also hundreds of technical indicators, most of which are derived from price and volume, that can help you to better visualize where a stock is in terms of investor sentiment.
The goal then with technical analysis is to enter into a stock when investor sentiment is changing from bearish to bullish, if going long, or from bullish to bearish, if going short. For example, if you are using a moving average of a stock’s price, you might want to enter a position when the price crosses above the moving average line. This may signal that sellers in the stock are done and that more buyers are starting to come in.
Why Does Technical Analysis Work?
Although those who dismiss technical analysis will tell you that things like price to earnings ratios, new products, economic cycles, and other fundamental factors are what move a stock, those things only are catalysts for buying and selling, the only things that moves a stock.
Technical analysis does not try to discern the fundamental reasons for buying and selling as they are usually too subjective and often not discovered until after a move has already been made. In fact, technical analysis is the “Joe Friday” of analysis – Just the facts ma’am!
Technical analysis looks for patterns of buying and selling, patterns that historically repeat over time, and then attempts to use that historical knowledge to predict future price movement. These patterns repeat because buying and selling is based upon the fear and greed of investors – emotions basic to human nature – which haven’t changed since the dawn of man.
What Are The Advantages Over Fundamental Analysis?
The biggest advantage that technical analysis has over fundamental analysis is related to lost opportunity costs. Most investors and traders have a finite amount of funds to work with, and fundamental analysis uses data and metrics, that even if accurate, have no time limit for success, which ties up capital indefinitely.
For example, if fundamental analysis tells you that XYZ Company is a buy because it’s becoming a major player in its sector, you may then invest some of your capital into buying the stock. However, your analysis doesn’t tell you when those fundamentals will begin to move the stock. It might be a week, a month, or a couple of years. By tying your money up for an unknown period you may waste a lot of time with little or no return and in the process miss out on other, more profitable opportunities.
In contrast, technical analysis -- by its nature -- relies on objective criteria and catalysts to signal an entry into a stock. That means that you only have to commit your capital to a position when those criteria and catalysts are triggered, allowing you more efficient use of your investing funds.
Technical analysis, just like any methodology, is not 100% accurate, but it can be a valuable tool, one which can be used in conjunction with other types of analysis to help improve your stock market returns.