The 3 Foundations of Technical Analysis, Simplified - Investing Shortcuts

The 3 Foundations of Technical Analysis, Simplified

A fantastic analogy below directly from Investopedia describes the differences between fundamental and technical investment data. They are two separate approaches to evaluating the markets for both identifying opportunities and managing positions.

In a shopping mall, a fundamental analyst would go to each store, study the product that was being sold, and then decide whether to buy it or not. By contrast, a technical analyst would sit on a bench in the mall and watch people go into the stores. Disregarding the intrinsic value of the products in the store, his or her decision would be based on the patterns or activity of people going into each store.

Think of the difference as calculating the costs of production, shipping, advertising and industry profit margin for that toy in the store versus the supply and demand factors of a dad who is expected to bring home a special gift. One is a statistical measure, and the other reflects emotional actions by purchasers.

The distinction is between determining value by fundamental accounting measures of the company and the technical price movements in the stock. Neither one is right nor wrong, they both simply provide a method for evaluation compared to other investments. They both have their place as trading tools in the markets.

Technical analysts believe that the historical performance of stocks and markets are indications of future performance. The chart patterns and technical studies lead to certain actions by investors that use those tools. In reality, technical analysis is sometimes a self- fulfilling prophecy for those who use it because they are looking for certain situations to act.

The basics of chart patterns illustrate floors and ceilings that prices have maintained. These areas of interest, support and resistance, are levels that technicians pay close attention to. Simply put, investors will watch to see if these levels hold or are breached to confirm stock strengths or weakness in price.

Whether or not support and resistance levels exist is not as important as the action of those investors that believe they do. As an example, if a stock has resistance above at $50 a share and has failed to rise above that level, traders may exit positions as it approaches that price on concerns of another failure to penetrate. Others could view a move above $50 a breakthrough and a sign for further strength.

In addition to the patterns from plotting a chart, many technical indicators can help measure some of the internal components that have moved prices. Dozens of studies analyze historical price data to help determine future action and direction. All of these calculations are attempting to determine the supply and demand pressures on

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.

From simple and exponential moving averages to ADX (average directional index), MACD (moving average convergence divergence), stochastics to RSI (relative strength index), leading and lagging technical indicators are designed give insight into price movement. The goal of technical trading is to develop a methodology for investment success. It’s valuable for some when identifying their trading candidates and managing positions to maximize the trends.

An underlying theme that’s stressed in all of our educational articles is developing trading discipline to minimize emotional decisions in the market. Technical analysis can provide a basis for a more mechanical approach to investing so that those actions can be replicated and repeated over time for financial success.

Often times, traders use both technical and fundamental reasoning for their personal investment choices. Sometimes the “how to trade” with solid money management rules is as important as what to invest in. No evaluation method is proven to be right or wrong but controlling investment risk on any and all positions is always an absolutely necessary part of trading.

Alan Knuckman

Author Alan Knuckman

Alan Knuckman is the Founder and Chief Market Strategist for a subscription trading service for his inner circle members. He has over 25 years of market experience that began in the pits of the Chicago Board of Trade as a runner and progressed to a Treasury Bond speculator. Each trading day Alan is the video host of the Morning Market Stir from the CME Group and the Pre Market Pulse on CBOEtv. He is also a frequent financial commentator appearing on television regularly with CNBC, CNN, Bloomberg, and Fox Business Network.

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