(Investopedia.com) – Many investors analyze stocks based on their fundamentals – such as their revenue, valuation, or industry trends – but fundamental factors aren’t always reflected in the market price. Technical analysis seeks to predict price movements by examining historical data, mainly price and volume.
It helps traders and investors navigate the gap between intrinsic value and market price by leveraging techniques like statistical analysis and behavioral economics. Technical analysis helps guide traders to what is most likely to happen given past information. Most investors use both technical and fundamental analysis to make decisions.
- Technical analysis, or using charts to identify trading signals and price patterns, may seem overwhelming or esoteric at first.
- Beginners should first understand why technical analysis works as a window into market psychology to identify opportunities to profit.
- Focus on a particular trading approach and develop a disciplined strategy that you can follow without letting emotions or second-guessing get in the way.
- Find a broker that can help you execute your plan affordably while also providing a trading platform with the right suite of tools you’ll need.
Choose the Right Approach
There are generally two different ways to approach technical analysis: the top-down approach and the bottom-up approach. Often times, short-term traders will take a top-down approach and long-term investors will take a bottom-up approach. In addition to this, there are five core steps to getting started with technical analysis.
The top-down approach is a macroeconomic analysis that looks at the overall economy before focusing on individual securities. A trader would first focus on economies, then sectors, and then companies in the case of stocks. Traders using this approach focus on short term gains as opposed to long term valuations. For example, a trader may be interested in stocks that broke out from their 50-day moving average as a buying opportunity.
The bottom-up approach focuses on individual stocks as opposed to a macroeconomic view. It involves analyzing a stock that appears fundamentally interesting for potential entry and exit points. For example, an investor may find an undervalued stock in a downtrend and use technical analysis to identify a specific entry point when the stock could be bottoming out. They seek value in their decisions and intend to hold a long term view on their trades.
In addition to these considerations, different types of traders might prefer using different forms of technical analysis. Day traders might use simple trendlines and volume indicators to make decisions, while swing or position traders may prefer chart patterns and technical indicators. Traders developing automated algorithms may have entirely different requirements that use a combination of volume indicators and technical indicators to drive decision making.
1. Pick a Strategy or Develop a Trading System
The first step is to identify a strategy or develop a trading system. For example, a novice trader may decide to follow a moving average crossover strategy, where they will track two moving averages (50-day and 200-day) on a particular stock price movement.
For this strategy, if the short-term 50-day moving average goes above the long-term 200-day moving average, it indicates an upward price trend and generates a buy signal. The opposite is true for a sell signal.
2. Identify Securities
Not all stocks or securities will fit with the above strategy, which is ideal for highly liquid and volatile stocks instead of illiquid or stable stocks. Different stocks or contracts may also require different parameter choices – in this case, different moving averages like a 15-day and 50-day moving average.
3. Find the Right Brokerage
Get the right trading account that supports the selected type of security (e.g., common stock, penny stock, futures, options, etc.). It should offer the required functionality for tracking and monitoring the selected technical indicators while keeping costs low to avoid eating into profits. For the above strategy, a basic account with moving averages on candlestick charts would work.
4. Track and Monitor Trades
Traders may require different levels of functionality depending on their strategy. For example, day traders will require a margin account that provides access to Level II quotes and market maker visibility. But for our example above, a basic account may be preferable as a lower-cost option.
5. Use Additional Software or Tools
There may be other features that are needed to maximize performance. Some traders may require mobile alerts or access to trading on the go, while others may leverage automated trading systems to execute trades on their behalf.
Tips and Risk Factors
Trading can be challenging, which means it’s important to do your homework beyond the above points. Some other key considerations include:
- Understanding the rationale and underlying logic behind technical analysis.
- Backtesting trading strategies to see how they would have performed in the past.
- Practicing trading in a demo account before committing real capital.
- Being aware of the limitations of technical analysis to avoid costly failures and surprises.
- Being thoughtful and flexible about scalability and future requirements.
- Trying to evaluate the features of a trading account by requesting a free trial.
- Starting small in the beginning and expanding as you gain experience.
The Bottom Line
Many investors leverage both fundamental and technical analysis when making investment decisions since technical analysis helps fill in the gaps of knowledge. By developing an understanding of technical analysis, traders and investors can improve their long-term risk-adjusted returns, but it’s important to understand and practice these techniques before committing real capital to avoid costly mistakes.
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