Technical analysis is one way to evaluate a stock to decide if it’s a good investment for you. If you’re a DIY stock trader, then understanding how this approach works can be helpful in shaping your portfolio. Here’s an overview of what technical analysis is and how you can use it to assess a stock’s potential.
What Is Technical Analysis for Stocks?
Simply put, technical analysis looks at how a stock has performed historically. Specifically, this means how pricing and trading volumes have changed over time. This is different from fundamental analysis, which looks at a stock’s current numbers for things like price-earnings ratio and dividend yield to measure its intrinsic value and the overall health of the company.
With technical analysis, the purpose is to look at what’s happened previously with a stock and use that information to gauge or forecast what may happen with its price going forward. This strategy relies on charts and other historical indicators to determine whether a stock’s current price is sustainable or if the price may drop in the future.
Remember, the key focus is on the stock price itself, not necessarily the financial strength of the underlying company that issued it. You’re assuming that all of the relevant factors that could affect a stock’s movements (profits, earnings, etc.) are already factored into its pricing history.
How to Use Technical Analysis to Evaluate Stocks
If you want to use technical analysis to compare stocks, you can follow a top-down process.
First, organize a group of stocks for which you want to conduct an analysis. For example, you could screen stocks based on their price and market capitalization. Market capitalization is the value of a company’s total stock shares at on the open market. So for example, if you have a set price point in mind you could screen out stocks that fall above or below that dollar amount.
From there, you could drill down further and screen stocks based on which sectors or industries they represent. You may want to focus only on financials or tech, for example. What you’re looking for here are patterns in a stock’s movements, either up or down, within its respective sector or industry.
This screening process is designed to help you narrow down the field to focus on just those stocks you want to conduct a technical analysis for. So while you might start with 50 to 100 stocks in your first broad grouping, it may whittle down to just five or 10 after reviewing pricing, market cap and industry trends.
Once you’ve got your shortlist of stocks to analyze, the next step is taking a closer look at them using two tools: chart patterns and technical indicators.
Chart Patterns
Stock charts show you movements in a stock’s price. When you’re reading a chart for a technical analysis, you’re looking for patterns that show where a stock has either had a breakout movement, meaning it’s moved significantly higher than its previous price, or it’s experiencing a pullback on pricing. Charts can also show you whether a stock is trending up or down in price and how prices are reacting to shifts in trading volume. Above-average trade volume, for instance, could suggest that a price breakout is on the way.
Technical Indicators
With technical indicators, you’re looking at specific numbers rather than a chart to decide which way a stock’s price is likely to go. For example, you might study the moving average which is just how a stock’s price fluctuates over a set period of time. The 200-day moving average tells you the stock’s average closing price over the last 200 days. You can study movements over shorter periods – 20 to 50 days – or look at longer timeframes depending on your objective for buying or selling a stock.
You’d use both chart patterns and the technical indicators to make your investment decisions.
Pitfalls and Limitations
No trading strategy is perfect, including technical analysis. Some of the most common pitfalls to watch out for include misreading stock charts or using the wrong moving average to make investment decisions.
This type of analysis may be more suitable if you’re trading frequently and need to get an idea of what a stock may do in the short term. On the other hand, if you’re more of a buy and hold investor, you may steer toward a fundamentals approach. Fundamentals investing places value on the overall financial health of the underlying company as a measure of whether a stock has the potential to be a profitable investment.
Bottom Line
The core idea behind technical analysis is that you can use trends in pricing to decide what you should invest in. If a stock does well, based on the expectations set by your analysis, then you stand to gain. However, your results may largely depend on how well you research different stocks and read the signals they’re sending to the market. Remember, the stock market can be unpredictable even on its best day. Technical analysis is just one tool you can use to navigate it.
What Is Technical Analysis?
Technical analysis is built on the idea that share price movements often follow a pattern that can be discovered through analysis of a security’s prices and the volume of shares traded. Those two metrics are assessed to find trends in the movement of a share’s price.
For example, if the average price of a share over a short time period, for example, 50 days, crosses above the moving average of a share price for a longer time period, for example, 200 days, technical analysts might see a buy signal. Likewise, if a stock’s 50-day moving average price falls below its 200-day moving average, technical analysts might see a sell signal.
Volume is the other key metric in technical analysis. Above-average trading volume, for instance, could suggest an imminent price breakout, either up or down. It’s important to note the focus is on the actual price of the stock, not the financial health of the company or industry or economy. When using technical analysis, you’re assuming all the relevant information is already in the pricing history.
Fundamental Analysis vs. Technical Analysis: Which Is Better?
For decades, the preferred and most credible method of evaluating stocks was fundamental analysis. As technology continues to advance and more information is widely available, this is changing. That means most investments first use black-box trading or computer modeling to determine the best investments. Most of the largest firms make investment selections using computer algorithms that use a combination of technical and fundamental factors.
When it comes to investors like you, you may feel comfortable using a specific strategy. You may also choose to use a combination of a few. Both fundamental and technical analysis provides tools for helping you make the best buying decision.
For example, let’s say you’re an investor who focuses on sustainable growth. Something that would be of interest to you is how a security or company will perform over a long period of time. Therefore, you may feel more comfortable using fundamental analysis.
Conversely, technical analysis uses data from short periods to identify patterns and, in turn, forecast performance. Since the data collection duration is brief, this method is often better for active traders looking for short-term returns.
On the other hand, fundamental analysis is potentially a better fit for those evaluating long-term investment decisions. That’s because fundamental analysis uses information that spans years at a time. Generally speaking, this gives more insight into securities that you may hold in your portfolio for a long time.
The Bottom Line
Fundamental analysis uses a variety of quantifiable metrics to determine the quality of a long-term investment, while technical analysis uses share price trends and trading volumes to decide what you should invest in when you have a shorter time horizon. If a stock does well, based on the expectations set by your analysis, then you stand to gain. However, your results may largely depend on how well you research different stocks. It also depends on how well you understand the signals they send to the market.
Remember, the stock market can be unpredictable. Fundamental and technical analysis are just two tools you can use to navigate it.
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