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.
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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.
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