Technical Analysis: The Basic Assumptions

What is Technical Analysis?

Technical analysis is a method of evaluating securities that involves a statistical analysis of market activity, such as price and volume. Technical analysts do not attempt to measure a security’s intrinsic value, but rather, use charts and other tools to identify patterns that can be used as a basis for investment decisions.

There are many different forms of technical analysis: Some rely on chart patterns, others use technical indicators and oscillators, and most use a combination of techniques. In any case, technical analysts’ exclusive use of historical price and volume data is what separates them from their fundamental counterparts. 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:

1. The market discounts everything.
2. Price moves in trends.
3. History tends to repeat itself.

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1. The Market Discounts Everything

Many experts criticize technical analysis because it only considers price movements and ignores fundamental factors. The counterargument is based on the Efficient Market Hypothesis, which states that a stock’s price already reflects everything that has or could affect a company – including fundamental factors. Technical analysts believe that everything from a company’s fundamentals to broad market factors to market psychology are already priced into the stock. This removes the need to consider the factors separately before making an investment decision. The only thing remaining is the analysis of price movements, which technical analysts view as the product of supply and demand for a particular stock in the market.

2. Price Moves in Trends

Technical analysts believe that prices move in short-, medium-, and long-term trend. In other words, a stock price is more likely to continue a past trend than move erratically. Most technical trading strategies are based on this assumption.

3. History Tends to Repeat Itself

Technical analysts believe that 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 uses chart patterns to analyze these emotions and subsequent market movements to understand trends. While many form of technical analysis have been used for more than 100 years, they are still believed to be relevant because they illustrate patterns in price movements that often repeat themselves.

Not Just for Stocks

Technical analysis can be used on any security with historical trading data. This includes stocks, futures, commodities, fixed-income, currencies, and other securities. In this tutorial, we’ll usually analyze stocks in our examples, but keep in mind that these concepts can be applied to any type of security. In fact, technical analysis is far more prevalent in commodities and forex markets where traders focus on short-term price movements.

Now that you understand the philosophy behind technical analysis, we’ll get into explaining how it really works. One of the best ways to understand what technical analysis is (and is not) is to compare it to fundamental analysis. We’ll do this in the next section.

For further reading, check out Defining Active Trading, Day Trading Strategies For Beginners and What Can Investors Learn From Traders?.