Seasoned stock traders and veteran investors do not rely mainly on fundamentals to make buy, hold or sell investment decisions when investing in the stock market. In addition to conducting fundamental analysis to determine a stock’s fair value, they also use technical analysis.
What’s the difference?
Fundamental analysis basically centers on the review of financial statements and all related financial and significant non-financial data submitted by publicly-listed companies. Technical analysis involves a statistical review of securities. Both methods are useful guides for investors to make well-informed investment decisions.
What is Technical Analysis?
By definition, technical analysis is a method by which securities are statistically evaluated based on market activities relative to price and volume. The method does not measure a stock’s monetary value but instead dwells on charts, patterns, and other tools to justify an investment decision.
Users of this method are referred to as technical analysts. The focus of these experts is historical data. They make use of past trading data and information to figure out future price movements. That differentiates them from the other school of thought or the fundamental analysts.
Basic elements of a stock chart
The primary tools for technical analysis are charts. Although charts come in numerous forms, the basic elements are all the same: a) price, b) time, and c) volume for the more detailed charts.
Traders plot the historical data of the stock in review on a graph. When completed, out comes visual representation. Traders are able to see the price movement over a given time frame. A future trajectory can now be made out before confirming a trade.
Basic assumptions of technical analysis
- The market considers ALL factors except price movements
Essentially, technical analysts see price movements as a product of supply and demand for a particular equity that is traded in the market.
Some market experts find fault with technical analysts because they only think through price movements. By ignoring the underlying fundamentals, their investment decisions are error-prone.
As a response to such criticisms, technical analysts argue that all broad factors – financial health, market news, business optimism – are already incorporated in a stock’s price or valuation. That is why they pay no attention to fundamentals. Hence, what is lacking is technical analysis to make the evaluation more detailed and accurate.
- Price movements establish a trend or pattern
Technical analysts have the confidence to make investment decisions based on price movements, whether in the short, medium, and long-term periods.
They are convinced that the price of a particular stock is likely to carry on from a past trend or establish a pattern. Thus, movements can be anticipated since stocks do not move unpredictably. This assumption is where the technical trading strategy is primarily based on.
- Past performance is likely to be repeated
Technical analysts believe that the historical performance of stocks will be mirrored in the future. They contend that price movements are repetitive in nature.
Price movements are often market-driven especially with earth-shaking news that could either trigger panic or generate excitement about a certain stock or the market in general.
With technical analysis, these emotions and ensuing market movements can be linked to the chart patterns. It will also result to better understanding of pricing trends. Technical analysts view their approach as the best way to illustrate patterns in price movements, which are recurring in most cases.
THE BEST USES OF TECHNICAL ANALYSIS
The most important doctrine of technical analysis is a trend. Even in the finance realm, the definition of trend is no different from its general meaning. A trend in the stock market pertains to the direction where the market or a stock is heading.
- Easy forecasting of price movements based on trends
By using charts, the movement of a market index or a stock price is clearly presented. Therefore, the technical analyst can easily distinguish any of the following trends:
- Horizontal or Sideways
The upward and downward trends are self-explanatory. The index or stock price can be on an upswing or downswing. The horizontal or sideways trend occurs when there is minimal movement, either up or down in the spike and dip of a trend. Technically speaking, a horizontal trend is actually the non-appearance of any distinct trend in either direction.
2. Easy identification of trend lengths
Apart from direction, the technical analysis also assists the trader to categorize trends according to their length. The duration or period is material because the timing of buying, selling, or holding can be determined based on the trend length.
- Short-term (one month or less)
- Medium-term or intermediate term (one to three months)
- Long-term (longer but can extend beyond one year)
By going deeper into analyzing trends within a period, short-term and medium-term trends may be embedded within a long-term trend. Thus, technical analysts can thoroughly analyze trends by breaking down the charts into periods of one day, five days, one month, one year or a year-to-date basis. They go into precise details in order to arrive at a sound investment decision.
3. Basic illustration
Let us take for example the Straits Times Index (STI), a major stock market index in Asia and the benchmark index for the Singapore stock market. It tracks the performance of the top 30 companies listed on the Singapore Exchange.
The chart below is the One-Year Chart of the STI Index as of January 22, 2018. From the period January 2017 to the current period, the index has been on an upward trend. The index stood at the 3,050 mark from a year ago. Today, the index is at the 3,550.30. The market grew in value by as much 16.4%.
STI Index / One Year Chart
The direction is generally upward but there are spikes and dips in between periods of the one-year trend. Charts of individual stocks are also available so you can analyse them using technical analysis.
In the chart below, it shows the performance of the STI Index over a five-year period (January 2013 to January 2018). In addition to the one-year trend seen in in the earlier chart, you can now see not just a trend but also a pattern.
STI Index / 5-Year Chart
Based on the examples above, there are good reasons to rely on technical analysis. Following trends can increase the chances of securing a winning trade. As a caution, even if trends or patterns are recognisable, the method may not be 100% precise. However, developing the skills can lead to a better prognosis of market or stock tendencies.
An important analytical tool
For newbies to the stock market, learning the technical analysis method would be advantageous. You can be more perceptive if you can combine this with your knowledge of fundamental analysis.
Keep in mind that in the stock market, the objective is to realise gains, mitigate risks, and cut losses. Having a basic understanding of technical analysis can shorten every neophyte’s learning curve.
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This is a guest post by ZUU Online, an Asian-based Finance Education Portal aimed at helping individuals to improve their knowledge on personal finance and money, through educational articles on business, investments, property and insurance.
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