What is Technical Analysis?
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Technical Analysis vs Fundamental Analysis
Technical Analysis is the practice of evaluating securities by analyzing their price and volume behavior and identifying price trends.
This is contrasted with Fundamental Analysis in which investments are evaluated by the financial performance of a company as evidenced through fundamental ratios such as gross margin and ROI.
The Definition of Technical Analysis
Technical Analysis is built on the assumption that a security’s price and volume history can serve as an indicator for future price movements.
Technical Analysis assumes that trading behaviors of other investors occur in patterns and that history will repeat itself.
Example of Technical Analysis
For example, Analysis Method A is developed on the premise that if a certain level of buy-volume occurs in the first three hours of market open, then investors should put a sell-limit at 1.5% higher than market open because the price of this specific security is statistically likely to decrease once it reaches this threshold.
This way, the trader will make money prior to the security’s value decreasing.
The Purpose of Technical Analysis
Generally, Fundamental Analysis is used to focus on a security’s long-term profitability, whereas Technical Analysis is used for anticipating short-term patterns which can be leveraged for short-term profits.
Technical Analysis has several limitations which investors must consider when using it.
The first is that history does not always repeat itself in the same way exactly.
Especially in efficient markets where information is symmetrical, investors will learn over time to preempt identifiable trends and behave differently, therefore changing the trend itself.
Similarly, Technical Analysis can be a self-fulfilling prophecy.
In our earlier example, if every investor uses Analysis Method A, then the security price will never reach 1.5% because the closer the security gets to 1.5%, the less investors will purchase it and push the price higher.