Technical analysis analyzes movements in momentum, mostly based upon price data but some forms may also take volume into account. It basically looks at where the price has been and uses this data to predict where it is headed.
The reason why momentum matters is that in any trade or any investment, where the price is headed does matter, although it is only when we focus on this that we are in a position to take advantage of this information.
Traders, who invest in shorter timeframes than investors do, enter and stay in trades as long as the numbers merit it, and when things turn against their positions to enough of a degree, then it’s time to exit the trade and move on to greener pastures, or often, trade in the other direction with the asset being traded.
What may happen in 10 or 20 or 30 years is of no significance to traders, who are only concerned with much shorter timeframes, like next week, tomorrow, an hour for now, or even a minute from now, depending on their trading timeframe.
Investors, on the other hand, don’t concern themselves with what happens in such a short period of time, and it doesn’t make sense for them to, unless they run into dramatic moves over this period. If that happens, we all need to be paying attention, at least if the moves are against us, to seek to protect our investments at a time where they may clearly need it.
This does not mean that only traders should be using technical analysis though, as it has the same validity regardless of the length of time and the scale that it is using, and works the same way basically on charts with monthly bars as it does with one second or one tick bars.
Why Technical Analysis is a Great Tool for Investors as Well
The real reason why technical data is used so much more by traders than investors is that those in the investment world tend to not be very familiar with it. In particular, they don’t realize that technical data is always valid, where fundamental analysis deals with incomplete and usually very incomplete data and is more like a guessing game than anything.
The main reason that fundamental data is inferior generally, regardless of the length of time we’re looking to hold an investment, is that even if the predictions that we make are valid and will happen more often than not, in other words are probable, their effect upon price isn’t directly related. Our technical analysis may be spot on in other words but it may not have the effect upon the market that we hoped.
A simple example of this would be our looking at a company that looks fantastic, and they continue to produce good results but their stock price may drop a lot over this time. That’s because there is quite a bit more going on than these business fundamentals, and where the price will go will ultimately depend on how the forces of supply and demand, the forces of those looking to buy and sell the stock, will play out over time.
The best way to know what’s happening with price isn’t to look to predict it based upon extraneous factors such as earnings growth, but to instead look to the way price in itself is moving and to act upon changes in price as it occurs.
With our example, we may look at the company’s fundamentals to decide whether it is a good investment or not, although we need not even worry about such things. Some traders may not even know the name of the company to trade it, they might just know it by its symbol, and the symbol along with its price history and other trading data is all you need really to do technical analysis.
If a stock is going up in value, it doesn’t matter why, as the movement in price in itself is what we are concerned about as technical analysts. We may jump on with a view of riding the movement until it peters out, and we can look at the particular move that it is in to decide whether it has the potential to move up enough to risk trading it as well as looking for signals that indicate that the ride is probably over, more likely than not that is.
You can do the same thing with investing in stocks longer term, or even better, you can just go with the market itself so to speak, investing in things like index funds or perhaps other types of investments such as precious metals.
We might think that this is in a sense investing blindly, but technicians would argue the opposite, with the view that investing without paying very close attention to price movement is what investing blindly really looks like, and that view actually has more merit.
Why Technical Analysis is Superior for Both Trading and Investing
If we are investing based upon fundamentals, and the market doesn’t co-operate, where we see a big loss over a certain period of time that can’t be blamed on fundamentals, we are completely unprepared to deal with these situations. We have no real choice but to hang on and hope that it comes back, and it very well may, although we may have been much better off staying out of it when this dissonance is going on and things are running counter to what we may expect based upon our fundamental analysis.
We usually don’t even worry too much about changing fundamentals anyway, and will very often just buy something and hang on to it and not even worry about the fundamentals changing. We also need to keep in mind that fundamental analysis needs to concern itself with both the micro fundamentals, business performance, as well as macro fundamentals, changes in the economy that drive investments prices.
Among the two forms of fundamental analysis, the macro data drives prices even more than micro data do generally, unless a stock is in dire straits or is outperforming the market by a very wide margin.
This is why we see so many stocks move together, either up or down, and the forces that drive these market moves are ultimately driven by investors, and their movements are often coordinated by these macro factors. Individuals are usually not concerned or even pay much attention to these things, but institutional investors do, which tends to lead the way when we see bull or bear runs based upon macroeconomics.
Then there’s the fact that good fundamental analysis takes some real skill and resources, the kind of things that large institutions have, but this is far away from the world of the average investor, or pretty much all investors actually. If we try out hand at this, we’re going to end up with, at best, only a part of the picture, and investing with information this incomplete just isn’t that wise.
It is far easier to become familiar with techniques that just look at prices on charts and then learn how to use this information to our advantage. Price data contains everything that influences prices, and is therefore complete data, and if there was something else that we should be influencing things and it does not, this extra information is simply irrelevant.
This question of relevancy represents the biggest difference between fundamental and technical analysis, where the data we get from fundamental analysis may have various degrees of relevance to price, but price data is always completely relevant to price because it deals with prices directly.
Investing Should Always Be Conducted on the Leading Edge
Some try to argue that the longer-term focus of investments require that we come up with a longer-term outlook to match, and the art and science of technical analysis really only concerns itself with what will happen next. What happens next may be a long way from when we are even considering making decisions about an investment, so there does seem to be a distance involved here, a disconnect perhaps.
This is much like taking a long drive and deciding that since our destination is so far away, we can afford to take our eyes off the road. Even if we are driving down a long and straight highway, with no turns expected for miles, we never really know how the drive will play out and we do need to be aware of what is going on in front of us.
We might say that we expect an investment to double in value over a certain amount of years, and this ends up coming to pass, so we congratulate ourselves and are happy we stayed the course here. There may have been several good opportunities along the way though, which we will have surely missed if we do not pay attention to the path in front of us.
Even though we may hope to hold an investment for decades, this does not mean that we don’t need to monitor the journey to our expected destination, and there just isn’t a good way to be certain enough about the paths this journey will take without watching the path unwind.
This is what we use technical analysis to do, to monitor the path in our chosen timeframe and look to spot obstacles and turn them into opportunities. People hate bear markets for instance since they are so married to the long side of investments, although there’s no easier time for investors to make money than in a bear market, where the moves are both bigger and more dependable.
Markets vacillate between greed and fear, with greed driving the bigger moves forward and fear driving things the other way. Fear tends to be a more powerful emotion though, because it can escalate into panic, and market crashes are completely panic driven.
Many investors are under the illusion that the prices of investments are driven by intrinsic value, or mostly intrinsic value, but the truth is, they are driven completely by investor behavior. Whichever side is on top at any given moment, the buy side or the sell side, will have their say and direct the price in that direction.
Technical analysis measures this sentiment, not as a prediction, but by using hard market data. If the price is moving up, it will continue to do so until the forces on the other side balance this and eventually take over and reverse the trend, and this is what technical analysis concerns itself with.
What is supposed to happen or what might happen outside of the current direction in prices doesn’t matter to the technician, but this is not a matter of ignoring relevant data, but instead being confined to it.
It’s little consolation that something may be regarded as bullish due to things like earnings growth when its price is plummeting and probably will continue to do so. This information will matter only if investors are buying more based upon this, but they often do not, leading to this not being an applicable factor and a real mistake to rely on and continue to do so throughout the decline.
It does take some real time, skill, effort, and understanding to become even a fair technical analyst, but this is easier to master than people usually think, and much easier than it is to become a good fundamental analyst. Fundamental analysis takes large teams of experts to do a good job with it, and even then, there’s lots of hope sprinkled in.
Ordinary folks with some time on their hands and a real interest in learning how to use charts to decide whether to stay in investments or not can really help themselves if they put in the time and effort to do so. Technical analysis is the great equalizer, a tool of the people, and allows us to get real leg up by watching the actual movie and not just some predictions of how good it may be to watch, or worse, to rent it and not even bother watching it.