
Investing – Financial Health Part 4 – What is Technical Analysis and how does it work?
This is Part 4 of our Company Financial Health Series
(click for Part 1 Determine a Healthy Company
and Part 2 Difference between Fundamental and Technical
and Part 3 What is Technical Analysis and how does it work?)
In Part 1 we looked at how to determine financially healthy companies to invest in. In Part 2 we looked at how share investors can tend to fall into 2 groups – fundamental analysis and technical analysis, and explained what is the difference between them – our experience is that both fundamental and technical, can help for increased share-market investment success. In Part 3 we looked in detail on what is.
In this final Part 4, we look in detail about Technical Analysis.
Technical analysis
Using the technical analysis means to chart a stock’s share price upward or downward momentum. A technical analyst follows share prices in order to align investors with on-coming positive or negative price action – that is, to forecast/prepare investors to BUY when share-price patterns and volume data are indicating potential sustained rising, and to SELL when charting is indicating a potential meaningful fall in a stock’s (or the market’s) share price/s.
Technical analysis believes that the past trading activity and price changes of a security are better indicators of the security’s likely future price movements, than the intrinsic value of the security. Technical analysis developed from basic concepts taken from Dow Theory (a theory about trading market movements that came from the early writings of Charles Dow). Two basic assumptions of Dow Theory that underlie technical analysis are 1) market price discounts every factor that may influence a security’s price and 2) market price movements are not purely random but move in identifiable patterns and trends that repeat over time.
Technical Analysis – How it is used
Technical analysis attempts to predict the future price movement of shares/stocks and virtually any tradable instrument that is generally subject to forces of supply and demand, including stocks, bonds, futures and currency prices. In another way, technical analysis can be viewed as the study of supply and demand forces as reflected in the market price movements of a security. It is most commonly applied to price changes, but some analysts may additionally track numbers other than just price, such as trading volume or open interest figures.
Over many years, numerous technical indicators have been created in attempts to accurately forecast future price movements. Some indicators are focused primarily on identifying the current market trend, such as support and resistance areas, while others are focused on determining the strength of a trend and the likelihood of its continuation. Commonly used technical indicators include trendlines, moving averages and momentum indicators such as the moving average convergence divergence (MACD) indicator.
Technical analysis applies technical indicators to charts of various timeframes. Short-term traders may use charts ranging from one-minute timeframes to hourly or four-hour timeframes, whereas other traders analyse longer-term price movements by scrutinizing daily, weekly or monthly charts.
Assumptions
One assumption, that price discounts everything, means the market price of a security at any given point in time accurately reflects all available information, and therefore represents the true fair value of the security. This assumption is based on the idea the market price always reflects the sum total knowledge of all market participants.
A second basic assumption underlying technical analysis, is that price changes are not random, leads to the belief that market trends, both short term and long term, can be identified, enabling market traders to profit from investing according to the existing trend.
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