After learning the basics of fundamental analysis, we now look at the “when” to buy shares, or sell shares. This is where the discipline of technical analysis is used. After a fundamental conclusion has been reached either to buy or sell a share, technical analysis is used to determine the perfect entry or exit point.
What is technical analysis?
Technical analysis is the study of data generated by the markets due to the behavior and psychology of market participants and observers. This methodology is usually applied to estimate the probabilities for the future course of prices in the market or an investment.
The misconception about technical analysis is that it's only about analyzing chart patterns, or for short-term trading. In reality, it has more to do with behavioral finance and analyzing market psychology, more than anything else. The discipline is also moving towards the quantitative analysis realm as artificial intelligence (AI) becomes more apparent in the world we live in.
Curious about the terms used by technical analysts? Below are some of the terms used within our research notes. Remember, these concepts have been expressed in layman’s terms:
Price action
Price action is the movement in a company’s share price plotted over a certain period. Price action forms the basis for all technical analysis of securities, which include stocks, commodities, and other asset classes like ETPs (Exchange Traded Products).
Trends
There are three major types of market trends analysts look at, namely: an uptrend (Bull market), a downtrend (Bear market), and a sideways trend (consolidation phase). Each of these trends represents a part of the market cycle. Most trends are cyclical which means that certain industries might exhibit the same growth patterns year after year.
Seasonality
Seasonality is also known as the annual cycle, or cycle of the sun, and is the most common natural cycle recognized as it can occur in almost all markets. It heavily influences the commodity markets. If you plan on investing in ETFs tracking a commodity, you want to make sure you know the seasonal trends of the commodity.
Surveys (market sentiment)
Surveys are also used to gauge market sentiment. One such survey that is used is the American Association of Individual Investors (AII), which measures the sentiment of individual investors. This is done weekly basis, along with other surveys, that track the opinions of investment advisers. The commitment of traders (CoT) report is also used to see the number of open positions in the futures market, known as open interest.
Support and Resistance levels
These levels are best described as psychological price levels, the demand for stock at certain price levels is perceived to be “cheap”, resulting in buyers jumping on board, thus forming a “support level”. The inverse of this is when the market is trending higher the sellers (supply) become more aggressive than the buyers (demand), deeming a stock to be expensive. That is when a “resistance level” is formed, with prices declining from that point.
Breakout
We refer to breakouts when the price of a share (or any other asset) moves above a resistance level or moves below a support level. Breakouts indicate the potential for the price to start trending in the breakout direction. Breakouts are usually confirmed if the price closes above the support or resistance level. To support the move, we would look to indicators like Volume (below) to support the breakout move.
Indicators
Indicators and oscillators are usually used to determine the direction of the market or underlying stock (or assets) and are usually visible at the bottom of a technical analyst’s chart. Indicators can be placed in two categories: one is to measure volume (the number of shares traded over a specific period), and the other measures momentum (which measures how quickly prices are rising).
We use the Relative Strength Index (RSI), which is a momentum indicator. The RSI measures the strength of a stock against its price history by comparing “up” days to “down” days.
Systems
Quantitative analysis and algorithmic investing (trading) systems are becoming more relevant, as the world evolves and Artificial Intelligence (AI) takes over. More and more investment institutions are leaning towards building algorithmic systems to invest in the financial markets, as this strips away human emotions.
Professional designations associated with Technical Analysis
If you are new to investing and analyzing market psychology, (or programming an algorithm is not your cup of tea) then it is always a good idea to consider the opinion of an analyst who holds a professional designation. The most recognizable (for technical analysts) is the Chartered Market Technician (CMT) designation. For risk managers, the Financial Risk Manager (FRM) designation and the Certified Financial Technician (CFTe) qualification which is also well-recognized.
Sources – Investopedia, CMT Association
