I think the best way to start our journey into learning about technical analysis (TA) is to compare it to fundamental analysis, and then discuss price action.
So let’s first review what fundamental analysis is.
But before we start, here’s a quick warning and reality check:
Based on some very reliable sources, mastering technical analysis is hard. It’s going to take us a lot of time and effort. Most people fail at trading because they don’t put enough work into technical analysis. That mixed with a weak mindset where you overtrading, gamble, or chase losses leads to failure. So you need to be disciplined and dedicated for the longterm to succeed with this.
What is Fundamental Analysis?
Fundamental analysis is likely more familiar to most people.
When you invest for the longterm, you’re going to use fundamental analysis. You’re going to study a company’s balance sheet, income statement, and cash flow statement to evaluate its financial health and growth potential. You’re going to look at what the company’s guidance is for growth over the next several years, the strength of their management and what competitive advantages they will have moving forward.
The aim of fundamental analysis is to predict the future price of a stock by determining whether it is undervalued or overvalued. This approach aids investors in making educated decisions about whether to buy, hold, or sell stocks in order to optimize their potential profits.
What is Technical Analysis?
Technical analysis focuses on the very short term.
When you’re day trading or swing trading, you’re buying and selling stocks over the course of minutes, hours or a few days. It’s very short term and therefore your trading strategy requires technical analysis. The fundamentals don’t matter.
You’re not concerned with the future of the company, and sometimes you might not even know anything about the company whose stocks you are trading. If you’re holding a stock for just a few hours or days, the company’s earnings reports or its financial health likely won’t impact your trading decisions.
As a day trader, your focus is all about studying the past price movements of a stock, along with the trading volume, to predict future trends.
An Overview of Technical Analysis
Technical analysis provides traders with a toolkit for assessing market conditions and potential future movements, relying on past and present data rather than the intrinsic value of a stock.
Here are some of the main categories of TA:
- Charts: These are visual representations of stock prices over time. They help traders see trends and patterns that might not be obvious from raw data alone.
- Candlesticks: A type of chart that shows the high, low, opening, and closing prices of a stock for a specific period. Each “candlestick” looks like a candle and can indicate whether the market moved up or down during that period. Learn how to read candlesticks here.
- Volume: This shows the number of shares (in stocks) or contracts (in futures) traded during a certain time period. High volume often indicates strong interest in a stock at its current price, while low volume might suggest less interest. Learn more about volume analysis here.
- Timeframes: These refer to the length of time that a chart covers. Common timeframes include daily, weekly, or monthly charts for long-term trends, and hourly or minute-by-minute charts for day trading.
- Price Action: This is a method where traders focus solely on price movements without using additional indicators. It involves looking at how prices have moved in the past to predict future movements.
- Patterns and Trends: These are specific shapes or movements on price charts that signal potential future movements. For example, a “head and shoulders” pattern might indicate a price is about to drop. Review candlestick patterns here.
- Indicators: Tools used to analyze past market data to predict future price movements. Examples include the Relative Strength Index (RSI), which can show if a stock is overbought or oversold. Check out our indicator guide here.
- Moving Averages: These are lines on a chart that smooth out price data to show the average price over a specific number of days. They help traders identify the direction of a trend. Learn more about moving averages here.
- Support and Resistance: These are price levels where a stock repeatedly stops falling or rising. Support is like a floor that a stock price doesn’t often go below, and resistance is like a ceiling that the price struggles to exceed. Learn more about support and resistance here.
The Philosophy of Technical Analysis
In chapter 1 of the popular technical analysis book Technical Analysis of the Financial Markets, the philosophy or rational of technical analysis is stated as:
- Price action discounts everything
- Prices move in trends
- History repeats itself
I have been following the $TSLA Tracker on X, and have learned a lot about over the past several months. Here is a post where he talks about price action:
Here is what this post on X says:
People keep telling me, price change requires news. And I’m trying to educate you that price action is a factor of sentiment in market participants. The media doesn’t trade stocks. They just report after the fact. News follows price action, not the other way around.
The words and opinions of people who aren’t buying and selling simply don’t matter. At the end of every day, all that matters is what people who trade, people who participated in the market, felt was a good enough price to buy or sell that day. You add all of that sentiment up over time, across millions of shares traded, and you get the price action of the market.
https://twitter.com/SBZung
Here’s a really simple breakdown of this post on X:
Many people think that news stories cause stock prices to go up or down. However, it’s actually the feelings and opinions of those who buy and sell stocks that mainly affect the prices. The news usually talks about these price changes after they’ve already happened, showing that stock prices often change before the news reports them.
Sometimes, stock prices might drop a bit, which helps traders guess where prices might go next. It’s important to pay attention to what the actual traders think and do, not just people talking about the stocks.
Every day, the main thing that matters is how much traders are willing to pay for stocks, based on how they feel about them. Over time, these feelings add up and are shown in the stock prices you see. This is what we mean by ‘sentiment’—it’s like a big group feeling about the stocks.
Simple Definition of Price Action (Market Action)
Price action is the way a stock’s price moves up and down over time. It’s what you see on a chart showing whether the stock’s price is rising, falling, or staying the same.
Detailed Explanation for Beginners
When we talk about price action in technical analysis, we’re focusing on the actual movements of a stock’s price, as represented on charts. This includes every dip, rise, or flat line you see when you look at a stock chart. Technical analysts use this visual information to try and figure out what might happen next with the stock’s price.
Here’s how technical analysts view price action:
- Understanding Sentiment: Price action is like a story that tells us how traders feel about a stock at any given moment. For example, if a stock’s price suddenly jumps, it might mean that a lot of people are optimistic about the company’s future. Conversely, if the price drops quickly, it could indicate that traders are worried.
- Charts as Tools: Analysts use different types of charts to study price action. These can include simple line charts, bar charts, or more detailed candlestick charts, which show not just the closing price but also the high, low, and opening prices for stocks during a certain period.
- Decoding the Market’s Language: Every change in price tells something about the market’s mood. Analysts look for patterns in the price movements that have occurred in the past to predict what might happen in the future. This could be identifying a repeated pattern that suggests a price might go up, or a different pattern that suggests a price drop.
- Price Action is Current: One key idea in technical analysis is that price action reflects all the available information about a stock. This means that whatever is publicly known about the company’s financial health, market conditions, and other factors, is believed to be factored into the current price.
By focusing on price action, analysts aim to make educated guesses about future price movements based on how prices have changed in the past, rather than getting bogged down in the specifics of the company’s financial details. This approach is based on the belief that the price itself, as it is shown on charts, is a direct reflection of everything affecting the stock’s value.
Understanding the Relationship Between News and Price Action
Technical analysis focuses more on price action and patterns observed in charts rather than the timing of news events. It assumes that news and events are already reflected in the price movements, and by analyzing these movements, traders can identify potential trading opportunities.
- Immediate Reaction: Technical analysts believe that the stock market is incredibly efficient at processing information. When news is released, the reaction to it (whether positive or negative) is almost instantaneous in the stock prices. This means that by the time most traders have heard the news and can react, the price has already adjusted to reflect the news.
- News vs. Price Action: It’s not that technical analysts think news won’t affect stock prices, it’s just they believe that by the time they could act on news, the price has already incorporated the news. Therefore, technical analysts focus more on what the price action shows rather than the news itself. They look at how prices have moved to understand the market’s sentiment and predict future trends.
- Sentiment and Psychology: Technical analysts often pay close attention to market sentiment—essentially the mood of the market. Even if the news is objectively “bad,” if the market sentiment remains positive, the price may not drop as much as one would expect. Conversely, even good news might not lift a stock price in a negative market environment.
An Example to Illustrate
Imagine a company announces unexpectedly high earnings, which is generally good news. You might expect the stock price to jump right away. However, if the price had been rising significantly in the days or weeks leading up to the announcement, it might not jump much further when the news breaks. This could be because market participants anticipated the good news and bought the stock ahead of the announcement, driving up the price in advance. When the news is officially released, the reaction might be muted because it was already priced in.
Conclusion Regarding News Events
For a technical analyst, the key is not just the news itself but how the market reacts to the news. By studying price action, they try to understand underlying market sentiments and make trading decisions based on the expected future movements, rather than reacting to news after it’s already influenced the market. This approach helps them focus on what they can see and measure—the price movements—rather than speculating based on news reports.
Price Action Discounts Everything
The idea that “price action discounts everything” allows technical analysts to focus directly on charts and models to guide their trading decisions, relying on the assumption that all necessary information is already embedded in the current price levels.
- Incorporation of Information: Technical analysts believe that anything that can possibly affect the price – fundamentally, politically, psychologically, or otherwise – is already factored into the stock price. This includes historical data, current events, future expectations, and market speculations.
- Market Efficiency: This concept aligns closely with the efficient market hypothesis, which suggests that stocks always trade at their fair value, making it impossible to consistently outperform the market through traditional stock picking. Technical analysts, therefore, focus on price movements and patterns to make their trading decisions rather than trying to assess a stock’s intrinsic value based on external data.
- Focus on Price Movement: Since the price is thought to reflect every factor that can influence it, technical analysts spend their time analyzing how prices have moved in the past and how they are moving now. This approach assumes that patterns will often repeat themselves or continue in a trend because they are driven by consistent human behaviors.
- Simplification of Analysis: By relying on the premise that price action discounts everything, technical analysts can simplify their analysis by focusing solely on price charts and trading volumes. This eliminates the need to digest vast amounts of fluctuating economic and financial data daily.
- Predictive Nature: Technical analysts use this principle to justify the predictive nature of their methods. They argue that if price movements incorporate all relevant information, then studying those movements can provide clues about future trends.
The principle that “price action discounts everything” forms the core of technical analysis, enabling analysts to concentrate exclusively on charts and price movements. This approach is built on the assumption that all relevant information, whether public or private, is already factored into the current prices.
By analyzing patterns and trends directly from the charts, technical analysts strive to forecast future market behaviors and make informed trading decisions without the need for additional external data. This method emphasizes the belief that the key to successful trading lies in understanding the signals the market provides through price movements.
