Now that you’ve got a grasp on how to build a strong portfolio with asset allocation and diversification, let’s explore a different approach some investors use to time the market: technical analysis.
If you think of building a portfolio as constructing the house’s foundation, then technical analysis is like using blueprints to understand how the market behaves day by day.
It’s less about which companies are good long-term investments (as fundamental analysis focuses on) and more about reading charts, patterns, and indicators to predict price movements.
At its core, technical analysis is the study of past market data, primarily price and volume, to forecast future price movements.
Instead of analyzing a company’s earnings or financial health (like fundamental analysis), technical analysis is all about the patterns and trends seen on a stock’s price chart.
Think of it like weather forecasting.
By observing patterns in the past (price trends, volume changes), technical analysts try to predict where the stock might be headed next. It’s not foolproof, just like weather forecasting isn’t, but many traders use these tools to help decide when to buy or sell.
There are a few basic tools and concepts to understand when diving into technical analysis. These might sound technical at first, but once you get a handle on them, they can be surprisingly intuitive.
Candlestick charts are the go-to visual tool for technical analysts. Each “candlestick” on the chart represents a specific time period (e.g., a day), showing four key pieces of information about the stock’s price:
If the closing price is higher than the opening price, the candlestick is usually green, showing a bullish move (the stock went up). If it’s lower, the candlestick is red, indicating a bearish move (the stock went down). Candlesticks form patterns over time, and technical analysts look for these patterns to make decisions.
Think of support and resistance as the floor and ceiling for a stock’s price.
Understanding these levels helps investors identify when to buy or sell. For example, if a stock is approaching a strong support level, it might be a good buying opportunity because the stock price could bounce back.
If it’s nearing resistance, it might be time to sell before the price drops.
A moving average is a line on a stock’s chart that smooths out price data over a certain time period (say, 50 or 200 days). It helps you see the stock’s trend more clearly by reducing the “noise” of day-to-day price fluctuations.
There are two common types of moving averages:
Moving averages are often used to spot trends. When the stock’s price moves above a moving average, it can signal a buy. When it falls below, it could signal a sell.
Volume refers to the number of shares traded during a specific time period. Higher volume often signals that something significant is happening with the stock. For example, a price rise accompanied by high volume could indicate strong interest, while a price rise with low volume might mean the move is weak and unsustainable.
Certain patterns in price charts are key indicators for technical traders. These patterns have names and signals that traders use to anticipate what might come next.
This is one of the most famous patterns and typically signals a reversal. Picture the stock price chart forming a peak (the head) with two smaller peaks on either side (the shoulders).
When the price falls below the “neckline” connecting the two shoulders, it’s often a sign that the price is headed lower.
A double top looks like an “M” on the chart and often signals the end of a price rally. The stock tries twice to break through a certain level but fails, suggesting the price is more likely to fall.
A double bottom is the opposite, resembling a “W,” and signals a potential bounce upward.
Triangles form when a stock’s highs and lows start to converge, creating a triangle shape. When the price eventually breaks out of the triangle, it usually leads to a strong move in the direction of the breakout.
While technical analysis focuses on price and volume data, fundamental analysis is about understanding the company behind the stock. For example, fundamental analysts might look at a company’s earnings, revenue growth, or competitive position to determine if it’s a good investment.
Here’s a quick comparison:
Some investors combine both methods. They might use technical analysis to figure out when to buy a stock and fundamental analysis to determine what to buy.
If you’re interested in using technical analysis, you’ll need a platform that provides charting tools. Most online brokerages offer these tools for free. Here are a few worth checking out:
There’s always debate in the investing world about whether technical analysis really works. Some traders swear by it, while others argue that it’s not reliable for long-term investors. It’s important to remember that technical analysis is just one tool—it’s not foolproof. Like all investing strategies, it requires practice and discipline.
Example: A 2020 study by the University of California found that only about 20% of day traders consistently made a profit using technical analysis, while the rest often lost money. This highlights the risks of relying solely on this method. That’s why many investors combine technical and fundamental analysis for a more balanced approach.
If you’re interested in learning more, start small. Begin by pulling up charts of stocks you’re already familiar with and practice identifying patterns like support, resistance, and trends. Set up free accounts on platforms like TradingView or TD Ameritrade to explore technical tools without risking real money.
Remember, technical analysis is a tool for making decisions about timing, not necessarily picking which stocks to invest in. Used alongside a solid portfolio strategy, it can help you make more informed decisions about when to enter or exit a trade.
