Last week, I introduced fundamental analysis. Today, I present you another way to analyze stocks – technical analysis.
What Is Technical Analysis?
Another area of stock research that has gained traction over the past few decades is technical analysis. This methodology emphasizes the study of a security’s past price movement along with other metrics, such as volume, to identify trading opportunities.
Simply put, a technical analyst believes that the past may be prologue in that a stock’s historical price movement may offer clues to its future direction. As such, technical analysis is often used to generate short-term trading signals with the help of various charting tools.
Charles Dow is generally credited as being the father of technical analysis when he began recording the movement of his creation, the Dow Jones Industrial Average (DJIA), in the late 1800s.
When a stock’s price movement is graphed, it can depict some distinctive formations. If these formations have an observable recurrence, they are defined as patterns. Basically, a chart pattern can be identified by connecting common price points during a defined time frame. Usually, this connection is made by drawing a line, called a trendline.
- A trend is defined as the overall direction of a stock’s price movement over a specified time frame. It is integral to the field of technical analysis.
- Uptrends are marked by higher highs and higher lows, while downtrends are marked by lower lows and lower highs.
- Popular chart patterns include double tops and bottoms, head and shoulders and inverse head and shoulders, rising wedges, triangles, and price channels.
The basis for technical analysis is rooted in following the price movement of a security. It is the data source from which most technical analysis tools are derived, with the possible exception of volume, which measures the amount being traded. In fact, most short-term traders only follow the price of a stock to make their trading decisions, paying no attention to its fundamentals.
- A stock’s chart patterns and formations are derived from its price movement plotted over time.
- All types of traders (day traders, scalpers, swing traders, and position traders) will follow the price of the security that they are interested in trading.
- Price movement, also known as price action, can be helpful to the trader in reading the market.
As the name implies, intermarket analysis involves examining the relationships among different markets or asset classes. For example, a correlation might exist between the U.S. stock and bond markets.
The logic is that what happens in one market could, and likely does, affect other markets. The markets might be positively or negatively (inversely) correlated, but as long as the connection is fairly strong, it could provide an edge to the trader.
- Intermarket analysis looks at the correlations among different markets or asset classes.
- Correlation results will range from -1.0 (perfect negative correlation) to +1.0 (perfect positive correlation).
- Usually, there is a negative correlation between stock prices and interest rates—when one goes up, the other goes down.