Technical analysis: Is your future fortune in the charts?

When you hear someone on the TV talking about shares, the chances are they will focus on "fundamental" factors, such as past and future earnings, industry prospects, and even the economic outlook. However, others argue that trying to beat the market like this is a fool's errand there are simply too many factors that can affect a share price. Instead, all you need to know about an asset is held in its price chart. This is known as "technical analysis" or "charting".

Broadly speaking, fans of technical analysis argue that prices are ultimately driven by human behaviour. Human behaviour doesn't change, which is reflected in the behaviour of prices. So smart investors can watch out for repeating patterns and harness this knowledge to their advantage.

Even if you find that hard to swallow, others argue that the popularity of charting among investors means it has an impact anyway. A 2010 Citigroup study of foreign exchange (forex) traders found that 56% took technical factors into account, while 33% used technical analysis exclusively. Of course, forex traders make very short-term bets, in which fundamentals hold little sway. But technical analysis is also often used alongside "fundamental" analysis.

Start your trial of MoneyWeek today

Get unparalleled financial insight, analysis and expert opinion you can profit from.

Start your trial

Sign up for MoneyWeek’s free twice-daily newsletter.

Join more than 165,000 subscribers and keep yourself informed with latest financial news, insights and expert analysis to help you understand what really matters when it comes to your finances.

Join more than 165,000 subscribers and keep yourself informed with latest financial news, insights and expert analysis to help you understand what really matters when it comes to your finances.

Sign up

An investor might track down a promising investment based on its fundamentals, then try to buy it at the best price possible, using technical analysis. Indeed, Britain's answer to Warren Buffett Anthony Bolton, very much a fundamental investor once told the FT that he consulted charts before buying anything, seeing "the technical situation as a summation of all the fundamental views available on a stock at that moment".

So what are the basics? The simplest way to study a price chart is to use "moving averages". This is simply the average price over a certain period (usually calculated using closing prices). So a 50-day moving average would be the average of the closing price over the last 50 trading sessions. If the current price is above the moving average, that's bullish (it suggests you should buy), but if it falls below the average, it's bearish (sell or avoid). Some traders use the moving average to determine their stop-losses (the price below which you should sell a stock). The "exponential moving average" is a variation that gives greater weight to more recent price data.

Another approach is to use "trend lines". This involves drawing a straight line on a chart connecting the price troughs or peaks, or both. The more points on the line, the more solid the trend. The idea is that, as long as the price does not breach the trend lines, the stock will continue rising or falling (or range-trading). Some traders also look for "breakouts", where a price breaches a previously strong trend line, as places to buy or to "go short" (aiming to profit by selling). Of course, this whole approach requires plenty of subjective judgement and depends on the timescale of the chart.

Other key concepts include "support" and "resistance". If a stock keeps hitting a certain level, but fails to go above it, that is "resistance". Similarly, a stock that never falls below a certain level has "support". Again, these may be seen as good times to sell or buy, or as opportunities to hunt for breakouts.

Much of charting boils down to buying or selling assets that are strongly moving in one way or another a type of momentum investing, which many studies have shown works. However, it's easy to get sucked into seeing technical analysis as an easy way to make money fast. It's not. Most of the tools rely on subjective judgements, and for most people, trading in and out of the market on a short-term basis will just prove an exhilarating way of losing a lot of money. In all, charting is a useful tool, but if you're a long-term investor, it should only form a small part of your process, if you use it at all.

Three other popular technical indicators

Moving averages, trend lines and support/resistance are some of the simpler concepts in technical analysis. However, there are many more complex indicators that traders also use according to taste here are three of the more common ones.

Moving average convergence divergence (MACD): MACD looks at the strength as well as the direction of a price trend. It is produced by subtracting the 26-day exponential moving average from the 12-day exponential moving average (charting packages will take care of the calculations these days). The further the MACD is from zero, the stronger the trend; the closer it gets to zero, the weaker the trend.

Bollinger bands: a more advanced version of support/resistance, invented by John Bollinger in the 1980s. This usespast price data and volatility to produce expected upper andlower bounds that a stock is expected to trade within. The ideais to buy when the stock is approaching the lower bound, sellwhen it is approaching the upper bound and follow the trend ifit breaks out of the bound.

Relative Strength Index (RSI): RSI is a popular tool thatmeasures the speed and strength of change in a price. Tradersoften use it to flag up when a strong run in either directionmight be coming to an end. The RSI is on a scale of 0 to 100.An RSI of over 70 suggests that the stock is overbought, anddue for a reversal. Similarly, an RSI of below 30 suggest abuying opportunity may be approaching.