Technical analysis is the art of reading a chart. As technical analysts, we look at price action from the past to help predict the future.
It is best to think of a stock chart in psychological terms because the chart patterns and candlesticks that have formed are built from actual transactions from investors. In essence, each chart represents the behavior of all types of investors including long term investors, traders, hedge funds, and speculators that participated in the chart by buying or selling the stock.
Because investors tend to act the same way in similar circumstances, chart patterns can be used to help predict certain outcomes or price direction in the future.
Part of the reason these patterns form is because not everyone gets the same information at the same time and when an investor does get information about a stock, he or she may not act on it right away. Trends in markets represent slow dissemination and assimilation of news.
Also, because the market is made up of human decisions, it is prone to swings of optimism and pessimism. We use technical analysis to measure these swings to make money.
What about Fundamentals?
What a company earns has a direct impact on its value. However, technical analysis does not consider earnings, financial statements, news, and product margins. Technical analysis assumes that all of this info is already priced into the chart. I will say though that stocks can have major moves after earnings reports or news releases such as FDA approvals in drug companies. So avoiding those known events is something to think about.
Forming the Charts
Chart patterns are not randomly generated. It’s true you won’t find a tradable pattern on every chart which simply means we will not trade every chart. But the tradable patterns we do find are formed when real people, acting in their own best interest, buy and sell stocks, bonds, currencies, or commodities in the pursuit of financial gain.
Investors act, the action is recorded and the sum of all participants creates the chart and forms the patterns we see. There is no randomness and there is no conspiracy.
You’ve probably heard the saying that “Only price pays”. The price of a stock should be seen as the sum total to date of the actions of everyone in the marketplace.
In today’s global market, information is released into the marketplace 24 hours a day. Some investors will act on this information quickly. Others will act more slowly and some won’t act at all.
There are those who get this information first and are able to act right away (think insider trading). As this information starts to leak around the market, people receive it and absorb it at different rates. The sum of all actions of all these people starts to leave discernible patterns on the chart. These patterns tend to repeat themselves as certain patterns tend to play out in similar ways.
Technical analysis involves chart reading to help predict future price movement of stocks. The main idea being that the chart is showing real transactions of others who are trying to make financial gains. As technical analysts, we use charting tools such as candlesticks, moving averages, and technical indicators to help us determine higher probability moves in stocks to make personal financial gain.