Technical analysis is a form of security analysis that bases decisions on volume and price data typically presented through charts. It can be used in freely-traded markets for a variety of securities. It is based on the premise that changes in prices are caused by changes in supply and demand and that prices can be projected using technical analysis tools.
Technical analysis does not require detailed knowledge about a security. It can be applied to any time series, short-term vs long-term as long as the underlying volume and price data show a trend.
Assumptions
Technical analysis is based on the assumption that markets represent collective knowledge and sentiment of a range of market sentiments. It highlights that since financial information is processed and trades are made by humans who are not completely rational (unlike the assumption made in fundamental analysis). Hence, they believe that markets are prone to trends that may be predicted and exploited for profitable trades.
While equity instruments and bonds have cash flows to which judgments can be applied to measure their intrinsic values, such an analysis is not possible in case of commodities, currencies, etc. This is why technical analysis is more popular in case of commodities, currencies, etc.
Technical analysis vs fundamental analysis
Technical and financial analysis differ in the following ways:
- Technical analysis is just based on the price and volume data while fundamental analysis focuses on analysis of information outside the market.
- The input in technical analysis, the price and volume data is more concrete and objective than the data used in fundamental analysis, (i.e. the information contained in financial statements), which is subject to estimates and judgments. However, once the analysis part starts, both processes become subjective.
- While fundamental analysis is more theoretical, technical analysis has a more practical focus.
- A price discrepancy (between market price and intrinsic value) identified by a fundamental analyst may not correct soon enough, but technical analysis acts fast. However, for technical analysis to be effective, trends must be in place for quite some time to be recognizable.
- Technical analysis ignores other available predictive tools and focuses solely on price and volume data and may sense a market move only once it has happened.
While technical analysis has been used in the 1700s in Japan, fundamental analysis became popular only after regulations required companies to provide information periodically to investors. However, during the last decade or so, there has been a renewed focus on technical analysis as a means to capture the role of investor psychology in market movements.
The effectiveness of technical analysis is limited where (a) there are significant external manipulations such as central market actions, (b) markets are illiquid.
Technical analysis is most effective when companies misrepresent their financial performance and position.