How Technical Analysis Works
Technical analysis is the field of predicting future performance in a financial market based exclusively on price charts. The field has many different strategies, both basic and complex. Few traders or investors participate in any stock or other entity without first consulting a price chart, so fundamental aspects of technical analysis are incorporated into most market decisions.
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Breakouts
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Most forms of technical analysis base their predictions on recurring patterns that exist in most financial markets. As a simple example of this, if a stock trades between two prices for a long time, and then it suddenly makes a move to a new high, this "breakout" often signals a change in how investors view the stock. Analysts see such a breakout and buy into the strength, sending the stock higher. This pattern occurs over and over again in the market and is easy to see on any chart.
Dow Theory
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Charles Dow, the founder of the "Wall Street Journal" and creator of the world's first stock market index, the Dow Jones Industrial Average, was the first analyst to outline specific methods for chart study. The "Dow Theory," his most significant contribution to technical analysis, lays down specific chart characteristics that a financial instrument must exhibit to be considered "trending." The pattern is easy to see. Any stock or other instrument fluctuates on a chart, creating "highs" and "lows" along the way. If you see "higher highs and higher lows" in succession, this is Dow's definition of a trend. This pattern is strong and widely followed today. A trend that exhibits this pattern can continue indefinitely, pushing prices steadily higher over time.
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Indicators
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While breakouts and trends are easy to see on an unaltered price chart, modern technical analysis makes use of software to further analyze price action. Technical "indicators" are chart lines and sub-charts that get added to an existing price chart. Each indicator has a specific formula that it uses, based on past prices, to derive a current real-time value. When these indicators' results for each bar on the chart are connected via a line, you get new ways to see changes in the market. Hundreds of indicators exist, and many traders use software that also lets them create their own indicators by experimenting with formulas. The most common example of an indicator is the "moving average," which simply shows how the average price over a set period of time is changing. Moving averages help some traders see past the volatility and recognize the overall price performance over time.
Chart Drawings
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You can also manually annotate your price charts using drawing tools. Most charting software provides this feature, which can help analysts study past price action. A "trend line" is a good example of this. If you can draw a straight line that connects all of the low points in a rising trend, then the trend is strong. But such a line also helps you predict when prices are likely to turn around in the future. As price declines toward the line, traders often speculate that the trend will continue. Prices often hit the line and bounce up, leading to new highs.
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