The methods used to analyze securities and make investment decisions fall into two very broad categories:
- fundamental analysis
- Technical analysis.
Technical analysis is a financial term used to denote a security analysis discipline for forecasting the direction of prices through the study of past market data, primarily price and volume.
Fundamental analysis involves analyzing the characteristics of a company in order to estimate its value. Technical analysis takes a completely different approach; it doesn't care one bit about the "value" of a company or a commodity. Technicians (sometimes called chartists) are only interested in the price movements in the market.
Technical analysis really just studies supply and demand in a market in an attempt to determine what direction, or trend, will continue in the future. In other words, technical analysis attempts to understand the emotions in the market by studying the market itself, as opposed to its components.
Technical analysis is based on three assumptions:
- The market discounts everything.
- Price moves in trends.
- History tends to repeat itself.
The Market Action Discounts Everything: A major criticism of technical analysis is that all relevant information is already reflected by prices, , ignoring the fundamental factors of the company. However, technical analysis assumes that, at any given time, a stock's price reflects everything that has or could affect the company - including fundamental factors. Technical analysts believe that the company's fundamentals, along with broader economic factors and market psychology, are all priced into the stock, removing the need to actually consider these factors separately. This only leaves the analysis of price movement, which technical theory views as a product of the supply and demand for a particular stock in the market.
Price Moves in Trends: Technical analysts believe that prices trend directionally, i.e., up, down, or sideways (flat) or some combination. This means that after a trend has been established, the future price movement is more likely to be in the same direction as the trend than to be against it.
History Tends To Repeat Itself: Technical analysts believe that history tends to repeat itself, mainly in terms of price movement. in other words, market participants tend to provide a consistent reaction to similar market stimuli over time. Technical analysis uses chart patterns to analyze market movements and understand trends.
Types of charts:
Open-high-low-close chart: OHLC charts, also known as bar charts, plot the span between the high and low prices of a trading period as a vertical line segment at the trading time, and the open and close prices with horizontal tick marks on the range line, usually a tick to the left for the open price and a tick to the right for the closing price.
Candlestick chart: Of Japanese origin and similar to OHLC, candlesticks widen and fill the interval between the open and close prices to emphasize the open/close relationship. In the West, often black or red candle bodies represent a close lower than the open, while white, green or blue candles represent a close higher than the open price.
Line chart: Connects the closing price values with line segments.
Point and figure chart: a chart type employing numerical filters with only passing references to time, and which ignores time entirely in its construction.