Imagine for a moment that you’re a surfer. To catch the perfect wave, you’ve likely had to do a lot of careful planning, from examining tide charts and clocking wind speeds to reading the patterns of waves as they break close to shore.
This same type of careful calculation can come into play when choosing the right time to buy and sell stocks, especially if you’re a practitioner of technical analysis.
What Is Technical Analysis?
Evaluating which stocks and figuring out when to buy and sell isn’t always easy. Technical analysis is an investment strategy by which investors try to forecast how a stock price will move based on current data on its past movements.
It uses various sets of data and indicators, such as price and volume, to identify patterns and trends. Technical analysis only considers a stock’s price and does not consider other factors, such as how a company operates, its earnings, or its assets.
Technical analysts chart this data to help them visualize patterns. Think of these charts as trails that stocks leave behind them as prices move up and down.
One of the basic tenets of technical analysis is that history tends to repeat itself. By examining these trails, and as patterns begin to emerge, analysts can make an educated guess about where stock prices might be headed when current patterns line up with historical patterns.
For example, it may become clear that stock prices move a certain way at a certain time of year. Consider a retailer that might see an uptick in share price during the holiday season.
Or, maybe it becomes clear that a stock reacts a certain way during specific market conditions. For example, when the price of steel rises, analysts may see a shift in the stock price of auto manufacturers.
Anyone can use technical analysis, though some of the indicators that professional analysts use to analyze stocks may be a bit on the complicated side. However, knowing some basics can be useful even for lay investors to help them make informed decisions about the stocks they choose.
Approaches to Technical Analysis
Investors may choose to take a top-down or a bottom-up approach to technical analysis.
Those who take the top-down approach will typically start looking at stocks from a viewpoint that starts broad and gets narrower. For example, they might look at broad indexes like the S&P 500 and narrow their search to individual stocks from there.
Top-downers will also look at individual stocks from a wide time frame to a shorter time frame, perhaps starting by looking at daily charts and zeroing in on hour-to-hour charts to figure out the best time to execute a trade.
When using a bottom-up approach, investors look immediately at individual stocks, searching for points at which the stock is perhaps undervalued that might provide an opening point at which to buy.
The Basics of Technical Analysis
Investors who use technical analysis have a number of tools available to help them analyze stock. Here’s a look at some of the most common tools and how they are used:
The main factor that technical analysis considers is price. Stock charts show how price changes over time, and technical analysts look for ways to read those charts to identify trends in price or other factors, like volume.
Technical analysts also consider how investor behavior, or psychology, can have big effects on how prices move. Understanding patterns in price can help analysts understand how other investors are likely to react under certain conditions given how they’ve reacted in the past to similar situations.
Technical analysis is all about keeping track of the trail that stocks leave behind. One of the ways that investors and analysts organize this data is with stock charts, including bar, line, and candlestick charts. These charts can cover wide or short time frames and show the patterns of how trades are executed.
You’re likely familiar with line and bar graphs in which the height of the bar or line illustrates the up and down movement of the stock. Candlestick charts may be a little bit less familiar and can be an extremely useful tool if you can read them.
Candlestick charts are made up of distinct pieces, “candlesticks,” that look like a cylinder with a line coming out of the top and bottom. The cylinder and the lines should be read as three parts. There are four pieces of data represented in each candlestick—opening price, closing price, and the high and the low.
Additionally, each candlestick represents a period of time. Say one candlestick represents five minutes. Within that five-minute period, the bottom of the body of the candlestick represents the opening price of a stock and the top of the body represents the closing price.
The line extending downward from the body represents the low within that time period, and the line extending upward represents the high. If the closing price is higher than the opening prices, the candlestick is colored green, and if it’s lower, the candlestick is colored red.
Each candlestick is read in the context of the other data points around it, and gives analysts a detailed look at how investors are buying and selling stocks over a given period of time. Certain candlestick shapes can be an indicator of distinct changes in the market.
A hammer candlestick has a low, low price, but its closing price is close to it’s opening price, indicating that prices have potentially hit a low and are reversing. It’s inverse, a shooting star candlestick, indicates that prices may have peaked and are on their way down.
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Technical analysis looks for trends that can help indicate the direction a stock price is moving. As the stock price goes up, it is on an upward trend. As it goes down, it’s on a downward trend. By comparing current trends to historical data, technical analysts may be able to predict where the trend is headed and what points may represent its highs and lows.
Analysts can measure the strength of trends and movement in price by taking a look at momentum indicators.
This indicator compares the most recent closing price to previous closing prices. In a stock chart, the momentum indicator is represented as a separate line from the price line.
Momentum indicators may be expressed as the difference between the current closing price and the closing price a certain number of periods ago. Or it may be expressed as a percentage, or rate of change, by dividing the current closing price by a past closing price.
The momentum indicator helps investors know whether the price of a stock is moving up or down, but, more important, it helps them know how fast it’s moving. When calculating the difference, a positive number means prices are moving up, while a price below zero indicates prices going down.
When calculating a rate, when the rate is above 100, the price is on an upward trajectory. When it’s below 100, the price is on a downward trajectory. How far the rate is above or below zero or 100 is an indication of how fast the price is moving. For example, a momentum of 90% is moving down faster than a rate of 95%.
In general, momentum indicators are used less to provide a signal that investors should make a trade than they are used to help support trades made based on other price actions. For example, if the price of a stock is moving down but downward momentum is slowing, it may help provide confirmation it’s a good time to buy if other indicators also show it’s a good time to buy.
Stock volume is a measure of the number of shares that are being bought and sold during a given period. Another way to look at volume is that it represents investor interest in a stock. The more stock being traded, the heavier the volume and the greater the interest.
Investors can look at volume as an indicator that prices are changing, and rising volume can be a sign that stock price is starting to move in a significant way.
That said, it is possible that high volume can represent the end of a trend. For example, investors hoping to take advantage of a rise in a stock price may pile on at the end as the stock price is reaching it peak and just about to fall.
Support and Resistance Levels
One of the patterns that analysts will look out for when looking at stock charts are certain thresholds at which stock prices tend to rise or fall. The support level is a point to which a stock will sink but won’t usually fall any further before rising again.
It is essentially the level at which demand is strong enough to bolster the price. Conversely, there is also frequently a price ceiling that stocks will hit that may cause prices to fall back down.
This is the resistance level, the level at which selling is strong enough to prevent prices from rising. Investors may pay attention to these levels, choosing to buy when prices are near the support level or sell as prices meet the resistance level.
Price movement over a given period of time can make a stock chart overwhelming to look at. The ups and downs of the line can be visually confusing and messy to look at. A way to simplify and show trends more clearly is by using a moving average.
This indicator focuses less on day-to-day movement and more on average price over time. A simple moving average (SMA) takes the sum of the closing prices over a given period of time and divides by the number of prices used. So if you were looking at a three-month period, you would add all the closing prices up over that period and divide by 90.
Technical Analysis vs. Fundamental Analysis
Fundamental analysis is another school of thought you may encounter when evaluating stocks. This strategy is a bit in opposition to technical analysis. For technical analysts, price is king. That’s why technical analysts are always looking at price and always looking for price patterns then can take advantage.
The fundamental analysis school of thought takes a deeper dive into a stock’s intrinsic value by looking at factors such as the underlying company’s financial statements, its assets and liabilities, how the company is governed, and the overall market and economy.
Whereas technical analysis is focused almost entirely on numbers, fundamental analysis looks at both qualitative and quantitative measures to determine the fair market value of a stock and compare whether its current price on the market is over- or under-valued.
That said, technical analysts would argue that the factors examined through fundamental analysis are already accounted for in the price of stock. As a result, they might say that examining price and trends is a more efficient form of analysis.
Technical Analysis and the Average Investor
The average investor interested in experimenting with technical analysis can turn to sites like Yahoo Finance or the Wall Street Journal . Each provides charts, data, and indicators, such as moving averages, that investors can use to track the past price and performance of stocks.
It should be noted that predicting the future price movement of stocks is very difficult. In fact, the efficient market hypothesis , states that because markets are efficient, stock price reflects all available information about a stock.
That sounds like technical analysis, right? However, according to the theory, past price and volume don’t have any bearing on the future price of a stock, which means that technical analysis wouldn’t work.
Many investors and analysts feel differently, but individuals should still be careful when choosing individual stocks. They may want to be sure that the stock is a good fit within their overall portfolio, aligning to both the investor’s asset allocation and diversification goals.
Investors looking to take a hands-on approach to buying and selling individual stocks can do so inside an active investing brokerage account.
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