How To Trade Technical Analysis
Before studying the actual techniques used in technical analysis, we must first understand what technical analysis is. We will also distinguish the differences between technical analysis vs. fundamental analysis.
Technical analysis is the study of past market data, through the use of charts, to predict a stock's future price. Technicians believe that anything that affects a stock price is reflected in the stock's price. Thus, if everything is already reflected in the market price, then we only need to study market prices. Just by studying price charts, you are indirectly studying the fundamentals of a company and whether the psychology of the marketplace for that company is bullish or bearish. For example, if prices are going up, we assume that demand must be exceeding supply, indicating that the fundamentals are bullish. If prices are falling, we assume that supply must be exceeding demand, indicating that the fundamentals are bearish.
An assumption of technical analysis is that history repeats itself. Because chart patterns have worked well in the past, we assume that they will continue to work well in the future.
With that understanding, the purpose of trading using technical analysis is to identify trends in their early stages so that you can trade favorably in the direction of those trends until it shows signs of reversing.
While technical analysis does not focus on the factors affecting the stock price, fundamental analysis does. Employing fundamental analysis includes studying a company's financial statements and earnings to determine a company's intrinsic value, or its actual worth. If the intrinsic value of a company is less than its market price, then the stock is overvalued. Similarly, if the intrinsic value of a company is greater than its market price, then the stock is undervalued and should be bought.
To sum up, trading using fundamental analysis studies the causes of market prices while trading using technical analysis studies the effect. As technicians, we believe that we do not need to know the reasons why the market moves since those reasons should already be reflected in market prices.
Many traders consider themselves as either fundamentalists or technicians. However, there are overlaps and some traders do study both methods. For our trading purposes, we are going to focus more on technical analysis techniques and tools.