Methodology

Stocks

Module 4

Test your knowledge

Technical Analysis

Technical Analysis

Technical analysis is a method that is used to analyse stocks to determine if they are worthwhile investments or not. It does this by looking for patterns in previous stock prices.

Investors that use technical analysis believe that they can forecast how a stock is going to perform in the future, based on the way that it has performed previously.

Technical analysis has no interest in the performance of the underlying business of a stock, instead it focuses on stock chart data.

For example, an investor that use technical analysis doesn’t care if a business has achieved record profits, instead they only care about the performance of the stock (i.e. trends).

If you are not sure what stock chart data is, it is the chart that most people think of when they think of the stock market. It is a chart that simply the chart that records the past performance of a stock.

Technical analysis is mostly used by short term investors (i.e. day traders and swing traders).

Assumptions in technical analysis

Technical analysis is based on three main assumptions.

Firstly, in technical analysts believe that all relevant information is already priced into a stock, which means that there is no advantage to be gained through information. Instead, they believe that stock prices change due to the supply and demand for that particular stock in the market.

Secondly, those that use technical analysis believe that stock prices move in trends, even if the stock market appears to be behaving in a completely random way. Therefore, they believe that making profitable trades is about identifying and following trends.

Finally, technical analysts believe that history repeats itself and that the past performance of a stock can be used to predict the future performance of a stock.

Having an understanding of these assumptions is important if you want to start trading with technical analysis.

Limitations of technical analysis

Although technical analysis is widely used by investors all over the world, there are several criticisms of the approach.

One main criticism is that history does not actually repeat itself, so study past performance of a stock is a waste of time.

This is because the performance of a stock is based on the performance of the underlying business and so anything can happen to that business. 

If the business fails, then the stock will crash, which is something that it wouldn’t have done before.

Furthermore, another criticism of technical analysis is that it doesn’t work all of the time. When it does, it could be the case that it only works because other traders have come to the same conclusion on a stock and made the same decisions, based on their ‘theory’, rather than something that is real.

Whether you decide to use technical analysis or not depends on your investment objectives. If you intend to invest over the short term, then technical analysis is likely to be more suitable than if you were to invest for the long term.

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