What Is Technical Analysis?

Technical analysis is the study of historical market data, including price and volume. Using insights from market psychology, behavioral economics, and quantitative analysis, technical analysts aim to use past performance to predict future market behavior. The two most common forms of technical analysis are chart patterns and technical (statistical) indicators.

What Does Technical Analysis Tell You?

Technical analysis is a blanket term for a variety of strategies that depend on interpretation of price action in a stock. Most technical analysis is focused on determining whether or not a current trend will continue and, if not, when it will reverse. Some technical analysts swear by trendlines, others use candlestick formations, and yet others prefer bands and boxes created through a mathematical visualization. Most technical analysts use some combination of tools to recognize potential entry and exit points for trades. A chart formation may indicate an entry point for a short seller, for example, but the trader will look at moving averages for different time periods to confirm that a breakdown is likely.

A Brief History of Technical Analysis

The technical analysis of stocks and trends has been used for hundreds of years. In Europe, Joseph de la Vega adopted early technical analysis techniques to predict Dutch markets in the 17th century. In its modern form, however, technical analysis owes heavily to Charles Dow, William P. Hamilton, Robert Rhea, Edson Gould, and many others—including a ballroom dancer named Nicolas Darvas. These people represented a new perspective on the market as a tide that is best measured in highs and lows on a chart rather than by the particulars of the underlying company. The diverse collection of theories from early technical analysts were brought together and formalized in 1948 with the publishing of Technical Analysis of Stock Trends by Robert D. Edwards and John Magee.

Candlestick patterns date back to Japanese merchants eager to detect trading patterns for their rice harvests. Studying these ancient patterns became popular in the 1990s in the U.S. with the advent of internet day trading. Investors analyzed historical stock charts eager to discover new patterns for use when recommending trades. Candlestick reversal patterns in particular are critically important for investors to identify, and there are several other commonly used candlestick charting patterns. The doji and the engulfing pattern are all used to predict an imminent bearish reversal.

How to Use Technical Analysis

The core principle underlying technical analysis is that the market price reflects all available information that could impact a market. As a result, there’s no need to look at economic, fundamental, or new developments since they’re already priced into a given security. Technical analysts generally believe that prices move in trends and history tends to repeat itself when it comes to the market’s overall psychology. The two major types of technical analysis are chart patterns and technical (statistical) indicators.

Chart patterns are a subjective form of technical analysis where technicians attempt to identify areas of support and resistance on a chart by looking at specific patterns. These patterns, underpinned by psychological factors, are designed to predict where prices are headed, following a breakout or breakdown from a specific price point and time. For example, an ascending triangle chart pattern is a bullish chart pattern that shows a key area of resistance. A breakout from this resistance could lead to a significant, high-volume move higher.

Technical indicators are a statistical form of technical analysis where technicians apply various mathematical formulas to prices and volumes. The most common technical indicators are moving averages, which smooth price data to help make it easier to spot trends. More complex technical indicators include the moving average convergence divergence (MACD), which looks at the interplay between several moving averages. Many trading systems are based on technical indicators since they can be quantitatively calculated.

The Difference Between Technical Analysis and Fundamental Analysis

Fundamental analysis and technical analysis are the two big factions in finance. Whereas technical analysts believe the best approach is to follow the trend as it forms through market action, fundamental analysts believe the market often overlooks value. Fundamental analysts will ignore chart trends in favor of digging through the balance sheet and the market profile of a company in search of intrinsic value not currently reflected in the price. There are many examples of successful investors using fundamental or technical analysis to guide their trading and even those who incorporate elements of both. On the whole, however, technical analysis lends itself to a faster investing pace, whereas fundamental analysis generally has a longer decision timeline and holding period by virtue of the time required for the extra due diligence.

Limitations of Technical Analysis

Technical analysis has the same limitation of any strategy based on particular trade triggers. The chart can be misinterpreted. The formation may be predicated on low volume. The periods being used for the moving averages may be too long or too short for the type of trade you are looking to make. Leaving those aside, the technical analysis of stocks and trends has a fascinating limitation unique to itself.

As more technical analysis strategies, tools, and techniques become widely adopted, these have a material impact on the price action. For example, are those three black crows forming because the priced-in information is justifying a bearish reversal or because traders universally agree that they should be followed by a bearish reversal and bring that about by taking up short positions? Although this is an interesting question, a true technical analyst doesn’t actually care as long as the trading model continues to work.

Further Reading:

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Stock sell-offs are tough for long-term buy-and-hold investors to swallow. But they are a necessary and natural element of a functional marketplace. Laws of supply and demand and investor appetite fuel both uptrends and downtrends. As investors, it’s important to be aware of both of these phenomena so that we can plan accordingly.

Sell-offs also conjure up a special vocabulary of finance and investing words in the media that may be unfamiliar. Here is a cheat sheet of some of that lingo for the next time you find yourself in a downdraft.

Bond Yields

Rising bond yields are often blamed for a sell-off in stocks. As the Fed raises overnight lending rates and the yield, or return, on U.S. Treasury bond prices rise, it makes them more attractive to investors, large and small, who are looking for a safer and less volatile place to put their money than stocks.

Bond yields have been so low for so long, but they are starting to creep higher, drawing more money to them and away from stock. Aside from their effect on equities, though, there are various reasons why yields matter.

Buy the Dips

“Buy the dips” is trader slang for buying securities following a decline in prices, with the inkling that they have fallen for no apparent reason and should recover and keep rising in short order. It’s kind of like an unexpected sale at your favorite retailer, except you think the value of the things you buy on that sale day will get more valuable over time. It doesn’t always work out in the stock market, but people like saying it.

Capitulation

In a way, you can think of capitulation as ripping your computer off the desk, hurling it across the room, and throwing the mother of all tantrums. But really it’s another way of saying that you can’t bear the losses anymore in a particular security or market and you are going to cut your losses and sell. When markets or a particular stock sell off in heavy volume, many investors are tempted to abandon ship and sell their stakes as well, or capitulate. That only exacerbates the losses.

Circuit Breaker

A circuit breaker is like the breaker box in your basement. However, this one can shut off the juice at the major securities exchanges. Exchanges like the New York Stock Exchange (NYSE) and Nasdaq are sometimes compelled to flip the switch when there is too much of an imbalance between sell and buy orders.

With more and more trades being pushed through computer algorithms, those imbalances can be more frequent. They last anywhere from a few minutes to several hours, but it’s all in the name of smoothing out the order flow so markets can effectively match buyers and sellers. Trading is halted for 15 minutes when a Level 1 circuit breaker is triggered by a 7 percent decrease from the S&P 500’s closing price.

Correction

In general, a correction is a 10% decline of the price of a security, market, or index from its most recent high. A correction should not be confused with a crash or just a bad day in the markets; these happen fairly frequently and can last anywhere from a couple of days to several months. Stocks can be in a correction before the index they are included in falls into one.

Implied Volatility

Implied volatility refers to the estimated changes in a security’s price and is generally used when pricing options. In general, implied volatility increases when the market is bearish—when investors believe that the asset’s price will decline over time—and decreases when the market is bullish—when investors believe that the price will rise over time.

Inflation

Simply put, inflation is the rate at which the level of prices for goods and services rises, which can drive the purchasing power of a currency lower. The Federal Reserve pays particular attention to rising inflation when it sets overnight lending rates or the Federal Funds Rate, as it is known.

Since the Fed has been raising rates of late and plans to continue to do so a few more times, at least, it makes borrowing costs more expensive which can impede growth and thus profits. It may sound complicated, but you can understand the relationship between interest rates and stock markets.

Short Selling

Basically, short selling is a bet that a security or index will decline wherein a short seller borrows shares to offer them for sale. The idea is to sell such shares, of which the short seller has no ownership, at a higher price hoping that the price falls by the time the trade needs to be settled. That would enable the short seller to acquire shares at the lower price and deliver them to the buyer, making a profit equaling the difference in prices.

While, if done right, short selling can be profitable, it can amount to massive losses if the trade goes the other way. It is definitely not a strategy for beginners.

Tariff

Tariffs are increased duties that are levied by countries on goods they import to protect domestic industries. These levies make the imported goods less attractive to domestic consumers. But even as this is expected to be a shot in the arm for the domestic economy, it has other consequences like upsetting trade partners who may retaliate, setting off a trade war. When this occurs with a significant trading partner, the future of large corporations that conduct business in those countries comes under question, putting pressure on the stock markets.

Volatility

Technically speaking, volatility is a statistical measure of the dispersion, or returns, for a given security or market index. That’s another way of saying it’s a measurement of change (or beta) of a security or index against its normal patterns or benchmarks it is weighed against. In the stock market, one way of measuring volatility is to look at the Chicago Board of Options Volatility Index (VIX).

There are many other ways to measure volatility, depending on what you are looking at or measuring. If you think of it as a measurement of the rate of change that reflects uncertainty or risk, you are on the right track.

In any asset class, the primary motive for any trader, investor, or speculator is to make trading as profitable as possible. In commodities, which include everything from coffee to crude oil, we will analyze the techniques of fundamental analysis and technical analysis, which are employed by traders in their buy, sell, or hold decisions.

The technique of fundamental analysis is believed to be ideal for investments involving a longer time period. It is more research-based; it studies demand-supply situations, economic policies, and financials as decision-making criteria.

Traders commonly use technical analysis, as it is appropriate for short-term judgment in markets, and analyzes the past price patterns, trends, and volume to construct charts in order to determine future movement.

Identifying the Market for Commodities

Momentum indicators are the most popular for commodity trading, contributing to the trusted adage, “buy low and sell high.” Momentum indicators are further split into oscillators and trend-following indicators. Traders need to first identify the market (i.e., whether the market is trending or ranging before applying any of these indicators). This information is important because the trend following indicators do not perform well in a ranging market; similarly, oscillators tend to be misleading in a trending market.

Moving Averages

One of the simplest and most widely used indicators in technical analysis is the moving average (MA), which is the average price over a specified period for a commodity or stock. For example, a five-period MA will be the average of the closing prices over the last five days, including the current period. When this indicator is used intra-day, the calculation is based on the current price data instead of the closing price.

The MA tends to smooth out the random price movement to bring out the concealed trends. It is seen as a lagging indicator and is used to observe price patterns. A buy signal is generated when the price crosses above the MA from below bullish sentiments, while the inverse is indicative of bearish sentiments—hence a sell signal.

There are many versions of MA that are more elaborate, such as exponential moving average (EMA), volume adjusted moving average, and linear weighted moving average. MA is not suitable for a ranging market, as it tends to generate false signals due to price fluctuations. In the example below, notice that the slope of the MA reflects the direction of the trend. A steeper MA shows the momentum backing the trend, while a flattening MA is a warning signal there may be a trend reversal due to falling momentum.

In the chart above, the blue line depicts the nine-day MA, while the red line is the 20-day moving average, and the 40-day MA is depicted by the green line. The 40-day MA is the smoothest and least volatile, while the 9-day MA is showing maximum movement, and the 20-day MA falls in between.

Moving Average Convergence Divergence (MACD)

Moving average convergence divergence, otherwise known as MACD, is a commonly used and effective indicator developed by money manager Gerald Appel. It is a trend-following momentum indicator that uses moving averages or exponential moving averages for calculations. Typically, the MACD is calculated as 12-day EMA minus 26-day EMA. The nine-day EMA of the MACD is called the signal line, which distinguishes bull and bear indicators.

A bullish signal is generated when the MACD is a positive value, as the shorter period EMA is higher (stronger) than the longer period EMA. This signifies an increase in upside momentum, but as the value starts declining, it shows a loss in momentum. Similarly, a negative MACD value is indicative of a bearish situation, and an increase further suggests growing downside momentum.

If negative MACD value decreases, it signals that the downtrend is losing its momentum. There are more interpretations to the movement of these lines such as crossovers; a bullish crossover is signaled when the MACD crosses above the signal line in an upward direction.

In the chart above, the MACD is represented by the orange line and the signal line is purple. The MACD histogram (light green bars) is the difference between the MACD line and the signal line. The MACD histogram is plotted on the center line and represents the difference between the MACD line and the signal line shown by bars. When the histogram is positive (above the centerline), it gives out bullish signals, as indicated by the MACD line above its signal line.

Relative Strength Index (RSI)

The relative strength index (RSI) is a popular technical-momentum indicator. It attempts to determine the overbought and oversold level in a market on a scale of 0 to 100, thus indicating if the market has topped or bottomed. According to this indicator, the markets are considered overbought above 70 and oversold below 30. The use of a 14-day RSI was recommended by American technical analyst Welles Wilder. Over time, nine-day RSI and 25-day RSIs have gained popularity.

RSI can be used to look for divergence and failure swings in addition to overbought and oversold signals. Divergence occurs in situations where the asset is making a new high while RSI fails to move beyond its previous high, signaling an impending reversal. If the RSI falls below its previous low, a confirmation of the impending reversal is given by the failure swing.

To get more accurate results, be aware of a trending market or ranging market since RSI divergence is not a good enough indicator in case of a trending market. RSI is very useful, especially when used complementary to other indicators.

Stochastic

Famed securities trader George Lane based the Stochastic indicator on the observation that, if the prices have been witnessing an uptrend during the day, then the closing price will tend to settle down near the upper end of the recent price range.

Alternatively, if the prices have been sliding down, the closing price tends to get closer to the lower end of the price range. The indicator measures the relationship between the asset’s closing price and its price range over a specified period of time. The stochastic oscillator contains two lines. The first line is the %K, which compares the closing price to the most recent price range. The second line is the %D (signal line), which is a smoothened form of %K value and is considered the more important among the two. 

The main signal that is formed by this oscillator is when the %K line crosses the %D line. A bullish signal is formed when the %K breaks through the %D in an upward direction. A bearish signal is formed when the %K falls through the %D in a downward direction. Divergence also helps in identifying reversals. The shape of a Stochastic bottom and top also works as a good indicator. Say, for example, a deep and broad bottom indicates that the bears are strong and any rally at such a point could be weak and short-lived.

A chart with %K and %D is known as Slow Stochastic. The stochastic indicator is one of the good indicator that can be clubbed best with the RSI, among others.

Bollinger Bands® 

The Bollinger Band® was developed in the 1980s by financial analyst John Bollinger. It is a good indicator to measure overbought and oversold conditions in the market. Bollinger Bands® are a set of three lines: the centerline (trend), an upper line (resistance), and a lower line (support). When the price of the commodity considered is volatile, the bands tend to expand, while in cases when the prices are range-bound there is contraction.

Bollinger Bands® are helpful to traders seeking to detect the turning points in a range-bound market, buying when the price drops and hits the lower band and selling when the price rises to touch the upper band. However, as the markets enter trending, the indicator starts giving false signals, especially if the price moves away from the range it was trading. Bollinger Bands® are considered apt for low-frequency trend following.

The Bottom Line

There are many technical indicators available to traders, and picking the right ones is crucial to informed decisions. Making sure of their suitability to the market conditions, the trend-following indicators are apt for trending markets, while oscillators fit well in ranging market conditions. However, beware: applying technical indicators improperly can result in misleading and false signals, resulting in losses. Therefore, starting with Stochastic or Bollinger Bands® are recommended for those who are new to using technical analysis.

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