Too embarrassed to ask: what is technical analysis?

Some investors don’t rely on a market or company’s fundamentals when assessing whether to buy or sell. They use “technical analysis” or “charting” instead. But what exactly is technical analysis?

There are two main approaches to investing in asset markets. One is to look at what are known as “the fundamentals” – for example, you might look at a company’s accounts to see how profitable it is, and to work out how much you should be willing to pay for it. You might also look at the wider backdrop – is the economy growing or weakening? What impact might that have on the sector?  However, there is another popular way to invest that ignores all of this entirely – that’s “technical analysis”, often referred to as “charting”. This involves looking at price charts to forecast the likely direction of the price of an asset. 

As far as hardcore technical analysts are concerned, all of the information you could possibly need to make an investment decision is already reflected in current prices. In other words, anything you can glean from “the fundamentals” has already been priced in. However, while there is always a flow of new information coming into markets, investors react to this new information in predictable ways. And because markets are cyclical, this results in recurring patterns of buyer and seller behaviour, which in turn will show up as recurring patterns on the charts. Being able to identify these patterns as they occur gives technical analysts an insight into what might happen next. 

In effect, technical analysis is built on an understanding that markets are driven by human greed and fear as much as they are by things like profitability and balance sheet strength.

Technical analysts employ a whole range of indicators and different types of chart. The simplest approach focuses on the idea that prices tend to “trend”, moving up,  down or sideways for long periods of time. So, for example, the path of least resistance for a stock that is moving up is to keep moving up. So a technical analyst might, for example, use moving averages – that is, plotting a line which takes the average of the asset price over a set number of trading days – to identify trends, and to measure how powerful they are.

Technical analysis may not sound very scientific, and like any other market approach, whether it “works” or not depends on who you ask and when you ask them. But its main purpose is to enable short-term traders to define clear entry and exit points for trades, which is something that fundamental analysis simply cannot do.  

To learn more about investing methods, subscribe to MoneyWeek magazine.

Recommended

The charts that matter: China upsets cryptocurrency markets
Global Economy

The charts that matter: China upsets cryptocurrency markets

Bitcoin slid again this week after China declared all cryptocurrency transactions illegal. Here’s what’s happened to the charts that matter most to th…
25 Sep 2021
How to cut your energy bill this winter
Personal finance

How to cut your energy bill this winter

Gas and electricity prices have risen by more than 250% so far this year. And they’re likely to go higher still Saloni Sardana looks at what can you …
24 Sep 2021
Cryptocurrency roundup: China’s crackdown intensifies
Bitcoin & crypto

Cryptocurrency roundup: China’s crackdown intensifies

Most major cryptocurrencies suffered falls this week as China cracked down even harder, while the Evergrande crisis rattled global markets, including …
24 Sep 2021
China Evergrande just missed a bond payment. Does it matter?
China stockmarkets

China Evergrande just missed a bond payment. Does it matter?

Troubled Chinese property giant Evergrande has just missed making an interest payment to some of its bondholders. That's not a surprise, says John Ste…
24 Sep 2021

Most Popular

Two shipping funds to buy for steady income
Investment trusts

Two shipping funds to buy for steady income

Returns from owning ships are volatile, but these two investment trusts are trying to make the sector less risky.
7 Sep 2021
Should investors be worried about stagflation?
US Economy

Should investors be worried about stagflation?

The latest US employment data has raised the ugly spectre of “stagflation” – weak growth and high inflation. John Stepek looks at what’s going on and …
6 Sep 2021
A nightmare 1970s scenario for investors is edging closer
Investment strategy

A nightmare 1970s scenario for investors is edging closer

Inflation need not be a worry unless it is driven by labour market shortages. Unfortunately, writes macroeconomist Philip Pilkington, that’s exactly w…
17 Sep 2021