Technical Analysis of the Stock Market
Technical analysis refers to the use of price patterns and volume to predict future valuations and trends within the stock market. Pure technical analysis ignores fundamentals, or the underlying economic conditions of the companies themselves. This strategy reasons that stocks are influenced by the behavioral patterns of investors, which have become predictable over time. Technical analysis, like all theories related to the stock market, will always spark controversy.
Other People Are Reading
-
Charts, Volume and Patterns
-
Technical analysts are traditionally referred to as chartists, who gauge price action and predict future movement by analyzing charts. Further, volume is used as an additional indicator to support these predictions. Volume refers to the amount of shares or capital that trades hands related to a particular investment and time frame. Price charts, combined with heavy volume, will produce and confirm familiar geometric patterns.
Typical chart patterns may be described as head and shoulders, flags and pennants, rectangles, wedges and triangles. These patterns always feature lines of resistance or support that behave as barriers for share prices to cross over and are used to predict trend.
The Trend is Your Friend
-
Technical analysis is used to identify trends and set off signals to investors whether to sell or buy into the market. Trend relates to the pattern of investments moving in one general direction. Assets that are behaving with a bullish trend are set to gain value, while assets following a bearish trend will lose value. Stock charts featuring higher highs and higher lows characterize bullish trends. Investments making lower lows and lower highs against resistance points are demonstrating a bearish trend.
-
Reversals
-
Investments will not continue upwards towards infinity, neither will investments fall to zero with regularity. Followers of technical analysis will also use the technique to identify "reversals" in trend, which mark switches between bullish and bearish sentiment.
The head and shoulders pattern is the most frequently cited predictor of a reversal. Advancing stocks that transition into declines will feature one peak, or head, which is surrounded by two lesser peaks that identify the shoulders. The "neckline" marks the low points beneath the head and shoulders.
Investor Behavior
-
Technicians believe that charts, trends and patterns are the end result of predictable human psychology. For example, support levels at $50 per share for Corporation X occur because individual investors reason that they will buy "if this thing drops to $50." Meanwhile, resistance levels emerge when the very same investors target $100 to sell out at a profit. Technicians reason that the stock market is controlled by irrational, yet regular investor behavior that repeats itself historically.
Investor behavior is deemed to be irrational because making a decision to buy or sell at a certain price point, irrespective of fundamentals, makes little economic sense. Further, investors always panic and liquidate at the bottom of a market, which is the worst time to do so.
Controversy
-
Academics have largely written off technical analysis as a "pseudo science." Fundamental analysts reason that economics, profits and management decisions influence share price performance. Meanwhile, "random walk" theorists postulate that stock price movements are variable and impossible to predict. These separate schools of thought both challenge technical analysis, which claims that price trends can be discovered and exploited due to predictable investor psychology.
-
References
Resources
- Photo Credit Wikipedia Commons - Public Domain
