Up until now we have been focusing on money management techniques. We have been assuming that there is only a 50% chance of picking a share that will go up. We have seen that even if we could only pick 50% winners, we can still make a profit.
Now imagine that we had some way to improve our chances of picking a winning stock to 60% or even 70%…
Welcome to technical analysis!
What is Technical Analysis?
Technical analysis (or “charting” as it is called) is the use of the share price information to evaluate a company. Most often technical analysts use charts to find patterns that might give them a clue as to which direction the market will move in the future.
All the Information is in the Price
Technical analysts believe that all the available information has been included and factored into the current share price. What we mean by this is to say that anybody who knows anything about a particular company (even if it is insider information known to them only) will act on this information to either buy or sell the shares. The buying and selling of these shares forces the prices up and down and forms certain patterns.
To put it simply, some of these patterns give us clues that people are buying the shares and will likely force the price to go up while other patterns tell us that people are selling the shares and that the price will likely go down in the future. These patterns are not always 100% correct but looking at them can certainly give you a much better chance than a 50 / 50 bet.
The idea of technical analysis works for private investors as they can monitor and predict the movement of shares by simply following a price chart.
Professional analysts will assess the share price and decide to either act to buy or sell the shares of a company. Using technical analysis, we can watch for signs of these professional players buying or selling to give us clues as to what a company’s shares might do next.
Recognition of Recurring Price Patterns
Regardless of why investors and professionals are buying and selling (this will be for different reasons each time), it can still make the same patterns on a chart. If we can learn to identify these patterns we can make assumptions as to which way we think the market is likely to go.
A really good way to get confidence in this type of approach is to get a chart of a stock and go back and search for the patterns you think may be significant. You can then see how well you would have faired in trading had you followed this approach. This type of testing is normally called “paper- trading” or “back-testing”.
This type of research is very important if you are going to succeed as a trader.
Charting Basics
Charting is the primary tool of technical analysis. Share price charts are a visual representation of the price that investors paid for stock at a particular time. This provides a graphical representation of price movements and allows us to take in a lot of information from one single picture.
There are many different types of charts including line charts, candlestick charts, swing charts and others. Most investors do this using software that takes the hard work out of drawing them by hand but it is advisable to draw some charts by hand when you begin because it will give you a really good feel for what it really means.
Summing Up Technical Analysis
Technical analysis gives you a real advantage when trading because it lets you swing the odds in your favour. Rather than guessing or listening to other people’s analysis, you have some hard numbers with which you can independently test your trading plan.
By studying the behaviour of historical stock prices with a view to identifying common patterns or changes in trend, technical analysts believe the chart information can provide them with some guidance as to what investors are going to pay for stocks in the future. For the technical analyst, price reflects crowd behaviour.
In this way, technical analysts don’t feel it is necessary to know the reasons why prices are moving up or down because they believe that any factors that affect the market price will ultimately be reflected in the market price. The aim of technical analysis is simply to determine the current state of the market and the likely outcome.
So, although the newspapers will often tell you what people say they are doing, a chart will reveal what they are actually doing – and what this is likely to mean for the future share price movement.