What Is Technical Analysis and How Does It Work?

Technical analysis is one way to evaluate a stock to decide if it’s a good investment for you. If you’re a DIY stock trader, then understanding how this approach works can be helpful in shaping your portfolio. Here’s an overview of what technical analysis is and how you can use it to assess a stock’s potential.

Do you have questions about investment analysis? Speak with a financial advisor today.

What Is Technical Analysis for Stocks?

Simply put, technical analysis looks at how a stock has performed historically. Specifically, this means how pricing and trading volumes have changed over time. This is different from fundamental analysis, which looks at a stock’s current numbers for things like price-earnings ratio and dividend yield to measure its intrinsic value and the overall health of the company.

With technical analysis, the purpose is to look at what’s happened previously with a stock and use that information to gauge or forecast what may happen with its price going forward. This strategy relies on charts and other historical indicators to determine whether a stock’s current price is sustainable or if the price may drop in the future.

Remember, the key focus is on the stock price itself, not necessarily the financial strength of the underlying company that issued it. You’re assuming that all of the relevant factors that could affect a stock’s movements (profits, earnings, etc.) are already factored into its pricing history.

How to Use Technical Analysis to Evaluate Stocks

If you want to use technical analysis to compare stocks, you can follow a top-down process.

First, organize a group of stocks for which you want to conduct an analysis. For example, you could screen stocks based on their price and market capitalization. Market capitalization is the value of a company’s total stock shares at on the open market. So for example, if you have a set price point in mind you could screen out stocks that fall above or below that dollar amount.

From there, you could drill down further and screen stocks based on which sectors or industries they represent. You may want to focus only on financials or tech, for example. What you’re looking for here are patterns in a stock’s movements, either up or down, within its respective sector or industry.

This screening process is designed to help you narrow down the field to focus on just those stocks you want to conduct a technical analysis for. So while you might start with 50 to 100 stocks in your first broad grouping, it may whittle down to just five or 10 after reviewing pricing, market cap and industry trends.

Once you’ve got your shortlist of stocks to analyze, the next step is taking a closer look at them using two tools: chart patterns and technical indicators.

Chart Patterns

Stock charts show you movements in a stock’s price. When you’re reading a chart for a technical analysis, you’re looking for patterns that show where a stock has either had a breakout movement, meaning it’s moved significantly higher than its previous price, or it’s experiencing a pullback on pricing. Charts can also show you whether a stock is trending up or down in price and how prices are reacting to shifts in trading volume. Above-average trade volume, for instance, could suggest that a price breakout is on the way.

Technical Indicators

With technical indicators, you’re looking at specific numbers rather than a chart to decide which way a stock’s price is likely to go. For example, you might study the moving average which is just how a stock’s price fluctuates over a set period of time. The 200-day moving average tells you the stock’s average closing price over the last 200 days. You can study movements over shorter periods – 20 to 50 days – or look at longer timeframes depending on your objective for buying or selling a stock.

You’d use both chart patterns and the technical indicators to make your investment decisions.

Pitfalls and Limitations

No trading strategy is perfect, including technical analysis. Some of the most common pitfalls to watch out for include misreading stock charts or using the wrong moving average to make investment decisions.

This type of analysis may be more suitable if you’re trading frequently and need to get an idea of what a stock may do in the short term. On the other hand, if you’re more of a buy and hold investor, you may steer toward a fundamentals approach. Fundamentals investing places value on the overall financial health of the underlying company as a measure of whether a stock has the potential to be a profitable investment.

Bottom Line

The core idea behind technical analysis is that you can use trends in pricing to decide what you should invest in. If a stock does well, based on the expectations set by your analysis, then you stand to gain. However, your results may largely depend on how well you research different stocks and read the signals they’re sending to the market. Remember, the stock market can be unpredictable even on its best day. Technical analysis is just one tool you can use to navigate it.