● What Is Technical Analysis?
Technical Analysis (TA) is a fancy name for something very simple—the study of past prices, usually in the form of stock charts, which is why practitioners of TA are often called “chartists.” Chartists study stock charts to predict future prices. Although this guide uses examples of stock charts, the principles work just the same on any type of financial instrument, including forex charts, futures charts, market indexes, etc.
Now let’s get started. Figure 1.1 below is a sample stock chart that a chartist might study:
Fig 1.1 Click to Enlarge. Chart courtesy of StockCharts.com
The details of the above chart will be explained shortly, but as you can see, there’s no reason to be intimidated. Technical analysis is almost completely visual. It doesn’t require a degree in finance or economics, nor does it require exceptional skill in mathematics. If you can read a chart, you can be a chartist.
● The Difference between Technical Analysis and Fundamental Analysis
Most have heard of fundamental analysis (FA). In fact, it’s the stock market investing strategy that most are taught first. FA looks at things like earnings, cash flow, debt or any other financial aspects of a company, i.e., the “fundamentals” of a company. “Fundamentals” can also refer to economic fundamentals affecting the entire stock market. A person using FA might study financial statements to discover what he thinks a company’s stock should be worth, then, if the stock is trading below that value, buy it hoping to make a future profit. In this way, FA is a stock market investing strategy concerned with the inner workings of companies.
In contrast, pure technical analysis isn’t concerned with financial statements, management or anything underlying a company’s business. Chartists only study how stock prices have behaved in the past and how that could affect them in the future. A chartist using technical analysis might buy and sell stocks knowing nothing about what the underlying company does. As a result, pure TA is a stock market investing strategy not concerned with the inner workings of companies.
For an example, a person using TA might notice that in the past year, every time XYZ’s stock goes down to $25, it soon bounces back up to $35. He would then buy XYZ at $25, hoping that it will bounce back up to $35 again. He doesn’t necessarily know or care why XYZ has been bouncing between $25 and $35, but he tries to profit from it nonetheless.
● The Better Stock Market Investing Strategy: Technical Analysis or Fundamental Analysis?
The ongoing debate between TA and FA alone could fill up a book. Ever since the concept of TA surfaced, hardcore fundamentalists have been saying that TA is worse than snake oil. On the other side are the avid chartists who swear that FA is a waste of time. Which is the better stock market investing strategy? It depends on whom you ask, but the answer is probably somewhere in the middle. Take the following two successful money managers:
Jim Rogers uses fundamental analysis exclusively and ran The Quantum Fund along with George Soros in the 1970’s. For the 30 years that the fund existed, it averaged over 30% a year-- phenomenal results relative to other funds and the S&P 500 index. When Jack Schwager, author of the Getting Started in Technical Analysis, asked Rogers about technical analysis, Rogers responded, “I’ve never met a rich technician. Excluding, of course, technicians who sell their services and make a lot of money.”
On the other hand there’s Marty Schwartz, a money manager who exclusively uses technical analysis. At the request of Jack Schwager, Marty had his past 10 years of trading records audited. The results were that over the previous 10 years, Marty averaged 25% a month, and during those 10 years, only suffered 2 losing months of 2% and 3%-- results too consistent to be attributed to chance. When asked about why he switched from fundamental analysis to technical analysis, Marty’s answer sounded like a rebuttal to Jim Rogers’ comment: “I always laugh at people who say, ‘I’ve never met a rich technician.’ I love that! It’s such an arrogant, nonsensical response. I used fundamentals for nine years and got rich as a technician.”
As you can see, there’s no consensus on whether TA or FA is the better stock market investing strategy; even the experts are divided. You’ll have to draw your own conclusions, but if you should care to look, there are plenty of books and research papers arguing both sides.
● They Can Be Friends After ALL
Even though experts argue about technical analysis vs. fundamental analysis, don’t let that fool you into thinking they’re polar opposites. You can use both in your stock market investing strategy, or realize they’re different versions of the same thing. Indeed, many chartists treat TA as a short cut to FA. Jack Schwager, long time chartist and author, elaborates:
“Technical analysis and fundamental analysis are more closely related than most would lead you to believe…[most chartists] do not dismiss the relevance of fundamental factors; they simply believe that price data incorporates and reflects these factors, and the best way to understand their impact on market behavior is to analyze charts.”
Others use both when selecting investments, using fundamentals for identifying sound investments, and then using TA to time their buying and selling. William O’Neil, founder of Investors Business Daily, is an advocate of using both TA and FA.
Charles Dow, founder of The Dow Jones Industrial Average, was also a man who used TA and FA. His Dow Theory resulted from a series of articles published in The Wall Street Journal between 1900 and 1902. In fact, the Dow Theory is thought by many to be predecessor to most principles of modern technical analysis.
Regardless of how you use technical analysis, it should not be ignored completely. When it comes to finding good stock market investing strategy, information is power, so you’re not doing yourself any favors by ignoring the charts. While extremists deny the utility of technical analysis, most reasonable people concede it has its place. Many major brokerage houses hire chartists, and the financial media often refer to it. At worst, learning TA will lead to a more thorough understanding of the market; at best it will prove to be a valuable money-making tool.