Technical Analysis

Technical analysis is the practice of evaluating a security by studying its own trading history, chiefly its past prices and volume as displayed on a chart, in order to identify patterns and time when to buy or sell it, without regard to the underlying company's financial condition. Where fundamental analysis asks what a business is worth, technical analysis asks what the security's own price and volume history suggest other market participants are likely to do next.

The distinction is about which data each method reads, not about which securities they apply to. Technical analysis can be, and often is, applied to the same stock a fundamental analyst is studying; the two are commonly combined rather than treated as rivals, with fundamentals used to choose what to own and technical signals used to time entries and exits.

The starting assumption is different from fundamental analysis's, and it is worth stating plainly. Technical analysis does not ask what a business is worth. It asks what other market participants are likely to do next, inferred from what they have already done, as recorded in the security's own price and volume. It treats the trading record itself as the object of study rather than as a proxy for anything happening inside the company.

The basic toolkit sits in a small number of categories. Trend identification asks whether a security has been moving up, down, or sideways over some window. Support and resistance mark price levels a security has repeatedly had trouble falling below or rising above, respectively, on the reasoning that a level tested and held before is more likely to hold again. A moving average is the average price over a set number of past periods, recalculated each day as the oldest period drops off the window and the newest one is added; it smooths out day-to-day noise so an underlying trend, or a change in one, is easier to see, and some traders watch for one moving average crossing another as a signal. Momentum indicators are a broad category of tools built to measure the speed and strength of a price move rather than its direction, on the reasoning that a move losing speed may be closer to reversing than one still accelerating.

The weak-form efficient market hypothesis is the direct academic objection. That theory holds that a security's current price already reflects all information contained in its own past trading history, which would mean a chart pattern carries no exploitable information about the future, because everything in it is already priced in. Our page on the efficient market hypothesis sets out that argument and its critics in full. Whether technical analysis produces returns that beat a comparable buy-and-hold position, after trading costs, is a genuinely disputed question in the finance literature, not a settled one, and this page does not take a side in that debate.

The horizon it is applied over varies enormously, and the label alone does not tell you which one. The same tools show up on a five-minute chart used by a day trader and on a weekly chart used by someone holding a position for months, and they imply very different opinions about how long a pattern is expected to matter. Our pages on day trading and swing trading describe two specific holding-period styles that commonly lean on this toolkit; this page describes the toolkit itself, independent of how long a position built with it is held.

Reading a chart is not an objective exercise, and that is the method's most repeated criticism. Two people looking at the identical price history can identify different trends, different support and resistance levels, and different signals from the same momentum indicator, because the patterns technical analysis looks for are not defined with the precision of, say, a company's reported earnings per share. That subjectivity does not by itself say whether the method has value; it says that any claimed result should specify exactly which rule was applied, because a different reasonable reading of the same chart can produce a different answer.

A trader studies a security's price and volume history, identifies a pattern such as a trend or a support level, and sets rules in advance for when to enter, where to exit if the trade goes wrong, and where to take profit if it goes right.

A hypothetical illustration of setting those levels. A stock has bounced off $47.00 three times over two months without falling further, and has stalled near $54.00 twice without breaking above it. A trader reads $47.00 as support and $54.00 as resistance, buys at $48.00 just above the support level, places a stop-loss order at $46.00, and sets a target near the $54.00 resistance level. The risk on the trade is $2.00 per share ($48.00 minus $46.00) and the target reward is $6.00 per share ($54.00 minus $48.00), a risk-to-reward ratio of 3 to 1. If the stock instead falls straight through $46.00, the stop-loss order closes the position at roughly that price, limiting the loss to close to the $2.00 per share that was planned for. All figures are illustrative, and nothing about the pattern guarantees the price actually respects either level.

Pros

• Works from market data alone, so it can be applied to any actively traded security without reading a single financial statement.
• Provides explicit, pre-set entry and exit rules, such as a stop-loss order, which can remove some in-the-moment decision-making from a trade.
• Applies over very short time horizons, where a company's financial condition is not expected to change and so has little to say.
• Long, continuous price and volume histories are available for most actively traded securities, so there is no shortage of data to study.

Cons

• Reading a chart pattern is not objective; two people can look at the same chart and identify different patterns or signals.
• The weak-form efficient market hypothesis directly challenges the premise that a security's own past prices predict its future ones.
• Trading driven by short-term signals realizes any gains at short-term capital gains rates and pays the bid-ask spread on every entry and exit.
• It says nothing about whether the underlying business is sound, so it can generate a buy signal on a company in real financial trouble.