Burton G. Malkiel writes in his book ‘A Random Walk Down Wall Street’ that ‘ the attempt to predict the future course of stock prices and thus the appropriate time to buy and sell a stock must rank as one of investors’ most persistent endeavours.’ Malkiel’s words are as true today as when he first wrote them for this classical investment book. There are many publications, TV shows and Web sites that attempt to help the budding millionaire stock investor identify when to buy or sell and their popularity seems to be growing each year.
Technical analysis is one way that is used by some investors to predict future price moves. Malkiel notes that ‘technical analysis is essentially making and interpreting stock charts.’ He goes on to say that practitioners of technical analysis ‘study the past- both the movement of common stock prices and the volume of trading- for a clue to the direction of future change.’
Here are some of the main attributes of technical analysis:
1. Technical analysis is based on observing human behaviour. The practitioner of technical analysis believes that investors react in similar ways to events that are repeated. When the price of a stock hits previous highs, for example, assumptions are made on the future course of the price based on what happened previously
2. By observing charts showing the price and volume of stocks, trends can be identified. The idea is that by charting the price action of a stock over time, the same patterns will be repeated, giving clues to future movements in price. For example, it may become clear that a stock has traded within certain boundaries for many months. When the stock price breaks out of these limits assumptions are made about future price movements
3. The concepts of support and resistance are important. Stated simply, support and resistance points are prices where the stock no longer goes down or up. For example, take the situation where a stock is falling in price. At some price, the sellers run out of steam and the price of the stock stabilises. At this point the stock price stops going down. By observing price charts, previous resistance levels can be identified and used as reference points to indicate future action
4. Stocks eventually breakout and follow a new trend higher or lower. The breakout from the previous price pattern may be caused by a change in the perception that investors have of the company prospects
5. There are a number of statistical measures that are important in indicating the future movement of stock prices. The practitioners of technical analysis will observe a number of statistical measures such as the moving average of the stock price. The moving average of a stock over, say 200 days, is used to determine the longer-term trend in the price of the stock.
Technical analysis is often compared to another method of predicting future stock prices called fundamental analysis. Fundamental analysis looks at measures determining what a stock is really worth. These measures may include the profitability and earnings of the company, the dividend payable and how earnings and dividends have grown in recent years. Practitioners of technical analysis may also refer to aspects of fundamental analysis before buying or selling a stock.
In summary, technical analysis uses charts showing stock price moves in the past and market volumes to attempt to predict future behaviour. Trends are observed and practitioners will be guided by the boundaries that a stock prise is moving within, breakouts and measures such as moving averages. Technical analysis can either be used in isolation or alongside fundamental analysis.