Stock-Picking Strategies: Technical Analysis

Technical analysis strategies are used to forecast future price moves by analyzing past and current market action. Unlike fundamental analysts – who evaluate a security’s intrinsic value – technical analysts use price charts and various analytical tools – including technical indicators and chart patterns – to evaluate a security’s strength or weakness and predict future price changes.

Why Technical Analysis Works

Technical analysis reflects the idea that prices move in trends that are determined by investors’ changing attitudes toward a variety of economic, monetary, political and psychological forces. As technical analyst John Murphy explains in his book, “Charting Made Easy”:

“Chart analysis (also called technical analysis) is the study of market action, using price charts, to forecast future price direction. The cornerstone of the technical philosophy is the belief that all factors that influence market price – fundamental information, political events, natural disasters and psychological factors – are quickly discounted in market activity. In other words, the impact of these external factors will quickly show up in some form of price movement, either up or down.”

Proponents of technical analysis argue the approach works because:

• Prices already reflect, or discount, relevant information.

• Prices move in trends.

• History repeats itself.

As a result, technical analysts believe historical market action can be analyzed to forecast future price moves. Of course, the effectiveness (and profitability) of any technical-analysis strategy ultimately depends on the quality of the analysis and the investor’s ability to respond to the results.

What Type of Investor uses Technical Analysis?

Anyone with a price chart and a ruler – or, better yet, an online or mobile charting platform – can use technical analysis to make investment decisions. That being said, it’s usually not the buy and hold investors who analyze price charts – they typically stick to fundamental analysis. Instead, technical analysts tend to be very active investors, holding positions for short periods to take advantage of price fluctuations – in both rising and falling markets. (See Introduction to Order Types: Long and Short Trades for more.) The length of time a position is held depends on the investor’s trading style; four primary trading styles are shown below:

What Technical Analysts Don't Care About

Pure technical analysts couldn't care less about the elusive intrinsic value of a company or any other factors that preoccupy fundamental analysts, such as management, business models or competition. Technicians are concerned with the trends implied by past data, charts and indicators, and they often make a lot of money trading companies they know almost nothing about.

Is Technical Analysis a Long-Term Strategy?

In a word, no. Technical analysts are usually very active in their trades, holding positions for short periods in order to capitalize on fluctuations in price, whether up or down. A technical analyst may go short or long on a stock, depending on what direction the data are saying the price will move. (For further reading on active trading and why technical analysis is appropriate for a short-term strategy, see Defining Active Trading.)

If a stock does not perform the way a technician thought it would, he or she wastes little time deciding whether to exit his or her position, using stop-loss orders to mitigate losses. Whereas a value investor must exercise a lot of patience and wait for the market to correct its undervaluation of a company, the technician must possess a great deal of trading agility and know how to get in and out of positions with speed.

Support and Resistance

An important concept in technical analysis is support and resistance, which is essentially a display of supply and demand. (See The The Psychology of Support and Resistance Zones for more.) Technical analysts use support and resistance to identify points on a chart where a pause or a reversal of the prevailing trend is likely to occur – events that can signal a trading opportunity. That’s because as price reaches a point of support or resistance, it will do one of two things: bounce back from the support or resistance level, or push through the price level and continue in its direction. Either way, traders can “bet” on the direction and quickly find out if they are correct. If price moves in the wrong direction, the position can be closed at a small loss. If price moves in the right direction, however, the move may be substantial. The following screenshot shows a daily chart with areas of support and resistance, drawn in yellow.

Technical Indicators

There are hundreds of technical indicators available to technical analysts, ranging from time-tested indicators in the public domain (such as a moving average or RSI) to commercially available proprietary indicators. Technical analysts can even develop their own unique indicators, sometimes with the help of a qualified programmer.

Whether a technical indicator is in the public domain or something you buy, it will fall into one of the four basic categories of technical indicators. The chart below shows these four types, along with examples for each.

Selecting Stocks

Technical analysts use indicators and other tools to find trading opportunities. A trader might, for example, watch a stock chart – ready to pounce if price moves above its 200-day moving average. There are countless technical analysis strategies and each requires a great deal of research and testing to ensure it will be viable. (Keep in mind, of course, that no investment strategy – whether it’s based on fundamental or technical analysis – can guarantee any type of results.)

Technical analysts can also use a tool called a stock screener to scan for stocks (and other trading instruments) based on user-defined metrics, including technical-indicator data and price patterns. For example, you could execute a screen for conditions like:

• Head and Shoulders

• Ascending triangles

• Strong volume gainers

• 50/200 moving average crossovers

• Move above upper Bollinger Band

The screener displays the results – those stocks that meet the specific criteria – and the investor can then enter positions or continue monitoring the stock(s) for further confirmation.

(For a closer look, see Basics of Technical Analysis.)