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 an asset's strength or weakness.
The main idea of the technical analysis is that "the price discounts everything". All the information you need to make your trading decisions is based on quotes, and in some cases also on volume.
From the quotes, the technical analyst tries to look for recurrent patterns that can predict the future behaviour of the price.
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Technical analysis may appear complicated on the surface, but it boils down to an analysis of supply and demand in the market to determine where the price trend is headed. In other words, technical analysis attempts to understand the market sentiment behind price trends rather than analyzing asset’s fundamental attributes. If you understand the benefits and limitations of technical analysis, it can give you a new set of tools or skills that will enable you to be a better trader or investor over the long-term.
Technical analysis is based on three assumptions:
- The Market Discounts Everything
Technical analysts believe that everything from a company’s fundamentals to broad market factors to market psychology is already priced into the stock. This removes the need to consider the factors separately before making an investment decision. The only thing remaining is the analysis of price movements, which technical analysts view as the product of supply and demand for a particular stock in the market.
- Price Moves in Trends
Technical analysts believe that prices move in short-, medium-, and long-term trends. In other words, a stock price is more likely to continue a past trend than move erratically. Most technical trading strategies are based on this assumption.
- History Tends to Repeat Itself
Technical analysts believe that history tends to repeat itself. The repetitive nature of price movements is often attributed to market psychology, which tends to be very predictable based on emotions like fear or excitement. Technical analysis uses chart patterns to analyze these emotions and subsequent market movements to understand trends. While many forms of technical analysis 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 asset with historical trading data. This includes stocks, futures, commodities, fixed-income, currencies, and other securities. In fact, technical analysis is far more prevalent in commodities and forex markets where traders focus on short-term price movements.