Fundamental analysis and technical analysis are two primary methods used to analyze securities and make investment decisions.
- Fundamental analysis involves analyzing a company’s financial statements to determine the fair value of the business.
- Technical analysis assumes that a security’s price already reflects all publicly-available information and instead focuses on the statistical analysis of price movements.
In other words, technical analysis attempts to understand the market sentiment behind price trends rather than analyzing a security’s fundamental attributes.
Technical analysis is a method of evaluating securities that involves a statistical analysis of market activity, such as price and volume.
Unlike fundamental analysts, technical analysts don’t concern themselves with a stock’s valuation – the only thing that matters are past trading data and what information the data might provide about future price movements.
Technical analysis is based on three assumptions:
- Everything from a company’s fundamentals to broad market factors to market psychology are already priced into the stock.
- Prices move in short-, medium-, and long-term trend.
- 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 can be used on any security with historical trading data. This includes stocks, futures, commodities, fixed-income, currencies, and other securities.
A trend is really nothing more than the general direction in which a security or market is headed.The overall direction of these highs and lows that constitute a trend.
There are three types of trends:
- Sideways / Horizontal Trends
A sideways trend is the absence of any well-defined trend in either direction.
In addition to their direction, trends can be classified in terms of their length. Most traders consider trends short-term, intermediate-term, or long-term.
Long-term trends occur over a timeframe of longer than one year; intermediate-term trends occur over one to three months; and, short-term trends occur over less than one month.
It is also important to remember that long-term trends carry greater weight than short-term trends.
Channels and Trendlines
A channel consists of two trendlines that act as strong areas of support and resistance with the price bouncing around between them.
Channels can slope upward, downward, or sideways, but regardless of the direction, the interpretation is always the same. Traders expect the price to trade between the support and resistance trendlines until it breaks out beyond one of the two levels, in which case traders can expect a sharp move in the direction of the breakout.
Support and resistance levels are psychologically-important levels where a lot of buyers and/or sellers are willing to trade the stock. When the trendlines are broken, the market psychology shifts and new levels of support and resistance are established.
Note that round numbers tend to be important support and resistance levels due to their psychological importance.
Also, a resistance trendline becomes a support level when price breaks it and stabilises.
Volume is expressed as a bar chart directly below the price chart with the bars height illustrating how many shares have traded per period.
The strength of any given price movement is measured primarily by the volume. In fact, a 50% rise in a stock price may not be all that relevant at all if it occurs on very little volume.
Volume is invaluable when confirming chart patterns, such as head and shoulders, triangles, flags, and other patterns. Chart patterns try to predict pivotal moments – like reversals. If volume isn’t present alongside these chart patterns, then the resulting trading signal isn’t as reliable.
Volume changes can be a precursor to price changes. If volume is decreasing in an uptrend, it could signal that the uptrend is coming to a close and a reversal may be likely.
Charts are simply graphical representations of a series of prices over time. The common denominator is that price is typically on the Y-axis and time is usually on the X-axis.
There are four types of charts used by traders and investors, including: line charts, bar charts, candlestick charts, and point and figure charts.
The most frequently used time scales are intraday, daily, weekly, monthly, quarterly, and yearly. Weekly, monthly, quarterly, and yearly charts are used to analyze long-term trends in stock prices.
Linear price scales have even spacing between each price point. Logarithmic scales look at price movements in percentage terms, which means that the spacing between each point is equal to the percentage change.
Check out the subsequent posts on Technical analysis.