It has always been the role of the active investor to eliminate the guesswork from stock market trading and to effectively determine which companies have the greatest potential to appreciate in market value within the shortest period of time. Given the large number of publicly listed companies in a single exchange, different filtering methods were sought to separate the stronger stocks from the weaker ones. Noticeable patterns in the historical data of stocks were soon discovered that could ultimately predict the eventual movement of share prices and the science of technical analysis was developed using this information to help active traders make more profitable investments.
Technical analysis is the study of market timing or market action. By reviewing past price movement, technical analysis uses charting systems and mathematically mathematically-drawn trend indicators to forecast future price reactions. Thus by evaluating price swings and patterns, one can make an educated assumption as to whether the share price of a stock was headed for a profitable gain or loss within a short term perspective. The foundation of technical analysis lies in its use of charted trends, the general direction of either the overall market or the price of an asset.
Although some evidence shows that traces of the science were dated as far back as the 17th and 18th century, technical analysis has been used in mainstream trading since the 1920’s- to 1930’s when Charles Dow and William Hamilton formalized price-trend concepts in an effort to understand the movement of markets. In fact, some portray Charles Dow to be the father of technical analysis given his originating views on the Dow Theory, a set of premises that served as the backbone for technical analysis arguments. Dow’s assertions discussed that price is the most important thing there is to study as it shows the end effect of supply and demand. If properly reviewed, price can reveal aspects about a stock’s trend, which can be followed and carefully predicted.
There are three key principles that serve as the basis for technical analysis:
- Price discounts everything else.
The market price tells you everything you need to know about a stock’s expectations regardless of company performance, book value, product development and so forth. There are various geopolitical factors that can affect the market price such as a change in government and natural disasters thus whatever the reason whether stemmed from logic or pure emotion, they will all factor in to the resulting share price of a company.
- Prices move in trends.
According to Newton’s Law of Motion.“An object in motion tends to stay in motion while an object at rest tends to stay at rest unless acted upon by an unbalanced force.” By recognizing familiar patterns in the daily or intraday price swings within the early stages of development, one can try to forecast the possible direction the share price will take simply by following that trend.
- History repeats itself.
People will tend to react in similar fashion to certain kinds of stimuli, thus encouraging a repetitive response to price activity. The market has a sharp and sensitive memory and traders will often recall what happened in the past in order to associate it with the future.
There is a great advantage when understanding technical analysis for active investors especially when supported by fundamentally strong research. Seeing prices through the illustrated form of charts and area patterns can quicken one’s trading as market timing does require faster decision-making. Ultimately, technical analysis also provides price ranges and boundaries for traders to work with so they can measure their potential risk-reward ratios. This allows them to make the most of their profit while managing their risk and guarding themselves against heavy drawdowns. In short, technical analysis prepares an active investor with a trading plan when choosing a potential stock candidate by executing the following rules:
- Looking for a justified entry. By estimating price targets, an active investor will have a better sense of when to enter into a trade at bargain valuations and not highly expensive prices when the upside for profit is less.
- Establishing an exit. Likewise, it is just as important to know when to exit from a trade whether to lock in profit or limit one’s loss.
- Assessing risk-reward. One must always evaluate one’s prospects. A key component to a successful trader is to determine one’s risk versus reward level, using that ratio to guide their investment decisions. It answers the question of whether the potential profit will be worth entering into a trade as compared to the potential losses.
Remember that learning the approaches of technical analysis can take only a few weeks or months to study but practicing and mastering its teachings will take a much lengthier time period of experience. A true technical analyst requires perseverance and emotional control to apply its theories and as the saying goes, it really is easier said than done. But with a strong sense of discipline and recognition, technical analysis will play an invaluable role in the financial success of any active investor.