There are lots of ways to evaluate stocks as potential investments, including the use of market activity to predict future movements. This is called technical analysis, and there's a subset of investors who rely heavily on it. Read on to learn more about this type of analysis.
What is technical analysis in investing?
Technical analysis is one way to predict stock movements based on historical stock data. So, instead of looking at how a company is performing, pure technical traders look only at stock charts and the stock's performance, including its price and trading volume.
The goal is to identify pricing trends and patterns to predict future opportunities. Technical analysis is generally used for short-term trading, often by day traders to pick up stocks they hope to resell quickly. However, it can also be used in combination with fundamental analysis to better understand both the company's and the stock's behaviors.
Technical analysis versus fundamental analysis
Here at The Fool, we generally teach how to examine a stock for the long term, and this includes fundamental analysis. That's when you look at a company as if you were going to invest in the business because, frankly, that's what buying a stock for the long term really is. You're buying a little part of the business, so you need a company that can go the distance.
In technical investing, you use technical analysis to buy stock based solely on its price and price potential, using historical trends. It can work if you have the right tools and are prepared to accept heavy losses when you're wrong.
Technical analysis is not for the faint of heart or for people who have a low risk tolerance. However, it can also be used with fundamental analysis to help predict where stocks you're holding long term may head in the future.
Common technical indicators
Technical analysts look at all kinds of patterns and trends, but some of the most common are also the most basic. When put together, they can create complicated systems that allow technical analysis to take place in surprisingly sophisticated ways.
These include:
- Pricing trends
- Charting patterns
- The amount and rate at which a stock's price changes
- High/low bands between price extremes, called oscillators
- The average changes in a stock price over time, called moving indicators
- Specific types of price pauses, called support and resistance levels
Limitations of technical analysis
Although many investors dabble in some form of technical analysis, often coupled with fundamental analysis, it's important to understand the limitations of this kind of examination. When we're investing, we have to be honest with ourselves about how and why we've chosen the stocks we have and not be blinded by our own biases.
Although fundamental analysis has its own flaws, it's much harder to miss with a stock over a five- or 10-year time horizon. When it comes to technical analysis, it's like jumping out of a plane and landing in the center of a trampoline -- everything has to be exactly right for the calculations to work out because the time horizon is so short.
Related investing topics
Some academics also believe there's literally no value in the historical data that technical analysts use, but this is a somewhat flawed argument since the same could be said about past business performance. People do tend to repeat behaviors over and over, which is what technical analysis considers. However, it's unlikely for all the elements that create a behavior to be exactly in line again and again.
Another argument against technical analysis is that results may be more of a self-fulfilling prophecy than an actual result of the analysis, since many technical analysts can influence prices up or down based on their behavior. If everyone is making the same calculations based on the same observations, it's easy to accidentally skew the results in the short term.
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