The Basics of Technical Analysis

This article begins a three-part series on the basics of technical analysis.

Technical analysis of the financial markets is the study of past price and volume movement to anticipate where prices are likely headed in the future. In addition to the many facets of this market discipline, there are also some widely accepted viewpoints of its value and how it should be applied.

In terms of technical analysis, when you are looking at the chart to determine the value of a financial instrument, you are not considering any of the underlying fundamental data of the core business or index it represents. Where a fundamental trader may consider a stocks P/E ratio to be important, a technical trader will examine the price action to determine whether the stock has value. Technical analysis relies on the visual display of supply and demand on a chart to determine how the market will respond going forward. One of the major underpinnings of technical analysis is that people’s actions and biases are reflected on the chart. People, to a certain extent are predictable in their reactions to certain situations. It is because of this repetitive behavior that you can use the charts to identify where the price action will behave in a similar way due to its past performance.

 Support and Resistance

While there are many disciplines within the realm of technical analysis, one of the recurring themes is the idea of support and resistance levels. Support and resistance levels on a chart represent key areas where supply and demand (in this case, buyers and sellers) often overtake one another. The support and resistance levels of the chart essentially make up the floors and ceilings of a multi-story building. Support levels serve as stabilizing areas where buyers sense a low price and a perceived discount of the stock. These levels make up the floors of the building. The resistance levels, or the ceilings of the building make up the areas where buyers are unable to move the price higher and the sellers take over. This dynamic between buyers and sellers creates the charts and subsequent levels.

Price Action

The idea of utilizing technical analysis to develop a thesis about a particular security is one that originates with “the tape”. The tape refers to the small, incremental changes in the price of a stock over time. The building blocks of the chart begin with compiling price data over a specific period of time ranging from minutes to weeks and months. As the trading action provides the open, high, low and close for a particular time period, the technical trader analyzes that aggregate data to identify key support and resistance levels.

The next article in this series will begin to examine technical indicators and the importance of volume and how it relates to price action.

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