The Simplest Way To Understand Technical Analysis | Exploring Markets

The Simplest Way To Understand Technical Analysis

What is technical analysis?

In financial markets there's no subject more debated or argued over than technical analysis. This post is here to calm the debate. What we're about to show you is a really basic explanation of what technical analysis is and how it looks.

One of the most important things to understand about technical analysis is that it is the study of supply & demand. In economics we are taught everything revolves around supply and demand. There is a marketplace of goods and services. They are then allocated or produced based on the amount of demand and supply for those goods and services. In technical analysis the same holds true. They are studying how much demand and supply surrounds a stock at any given time.

How do you see supply and demand in technical analysis?

A chart can tell you everything about the supply and demand of that specific asset. On charts you can see the price of that asset, its volume, and the general direction over a specific period of time. This, at its core, is supply and demand being illustrated to the world on a chart.

What does technical analysis look like?

Go to a stock market website or your brokerage account and type in a symbol. Like AAPL (Apple). Then find the chart feature and open it. Now you will have price, volume, time, and a ton of options to overlay on this. Here's where technical analysis becomes a massive subject with thousands of sub-concepts. While the core of technical analysis is supply and demand, it has evolved into many derivatives of that. Some are amazing, others confusing or even flat out mind-blowing. Let's start with a simple example:




How do you understand technical analysis?

In the example above, you see a chart of Apple from 2011 to 2013. This is a daily chart. That means each candle bar (the red and green rectangles) is the opening and closing price of Apple's stock price at the start and end of each day. The blue line on this chart is the 20-day moving average. This is the average price of Apple's stock price over a timeframe of 20 days. There are countless ways you can create this chart. You are seeing how a marketplace has bought and sold Apple. A technical analyst might look at this chart and see the market was uncertain about Apple throughout 2011. Look how it traded sideways for that entire year without any major move lower or higher. However, when the year turned to 2012, demand kicked in. Something changed and the trend swiftly exploded higher. Look at the 20-day moving average, too. Pay attention to how fast it turns higher and climbs with the stock price. Now see those yellow circles? That shows something called support and resistance. Each time Apple had any meaningful sell-off, its price found support and resumed climbing higher.

A technical analyst might have seen this chart back then and said something like "Apple is an uptrend. Its moving averages are acting as support. Demand is there and a good trade might be to buy Apple now and hold. There is one condition though. We need to sell it if it goes below its key moving averages because that would signal fleeing demand in my opinion." Look at the chart again and think about how this makes sense.

What are the different ways to use technical analysis?

Here's the thing. Technical analysis has evolved drastically over the last 100 years. It started as a method of studying supply and demand. Now with the power of computers, technical analysis can do just about anything. You can run backtests on price. For example, what if you wanted to know how Apple traded every single time it climbed 5% in a week? You can easily study that. What if you wanted to know how Apple traded each time the moon was full at midnight? That sounds silly but some people actually think the moon impacts how people trade the stock market so they study that. The point here is that technical analysis now means a lot. It's not only the study of supply and demand, it's also the study of interlocking relationships. It's also now the study of market psychology and sentiment. You can literally study trader sentiment polls (how bullish and bearish people are) vs. the stock market at any given moment.

What's the final debate about technical analysis?

When it comes to the stock market, there are people out there who think technical analysis is a joke. That it's silly or a complete waste of time. These people are generally business school people or disciples of value investing. Their reasoning is that the price on a chart yields no insight into the future. Instead you need to know earnings, press releases, and the fundamentals of the company. While they have a point that this is true, little do they know when they find a company they love and start acquiring it, there's a technical analyst out there studying for supply and demand. That technical analyst will find your same stock eventually.

In markets, you need to keep your mind open. There is no one theory wins all. It's a race to what's working and your job is find it and buy it. Whatever makes you money – do it!

DISCLOSURE: The authors of this blog use fundamental research and technical analysis. We are an open and free thinking group of investors and find value in the tools that work.