Become a better investor
Lesson in Course: Stocks (beginner, 6min )
I keep hearing of experts reading charts. What is it and do I need to do it to be a successful investor?
Technical analysis is a quantitative approach requiring stock traders to look at charts to time the markets. Technical analysis differs from fundamental analysis because technical analysis looks at the price movement and the supply and demand for a stock compared to fundamental analysis, which looks at the business's health.
Technical analysis is not necessary to become a successful investor; however, it can help determine how to deploy our capital.
Traders, speculators, and investors use technical analysis. Traders and speculators favor the technique over longer-term investors. Day-traders are speculators who buy and sell security intending to buy low and sell high. Institutional traders, such as market makers, help investors execute large purchases and provide liquidity to the market.
Market makers and executers use charts of live trading data to understand the supply and demand for shares at any given time. Market makers sell shares if the demand is significantly greater than the supply and act as a buyer of shares if the supply outweighs the demand. Their job is to make sure the bid and ask prices doesn't swing wildly.
Traders working for banks or brokerages use charts to determine how to enter and exit large positions without moving the market. For example, when Warren Buffet decided to sell his shares in airline companies in response to COVID-19, he would have hired out traders at different brokers to exit his position worth $4 billion. Traders decided how many shares to sell and at what bid price without tanking the market.
Speculators or day-traders often trade with their capital, and they read the charts to try to time purchases before a bull run in the stock price and sell their positions before the stock price drops. These traders don't care much about the company's business developments but focus more on the volatility and price action. As we can expect, technical analysis is also very popular with assets that don't have much fundamental analysis tied to them. These assets include commodities and currencies.
Long-term investors also choose to use technical analysis. Instead of trying to time short-term trades, long-term investors use charts to time entry points. If we decide to avoid dollar-cost averaging, we can adjust the size of our purchases and choose to make the purchases based on the supply and demand of the shares. Historically, timing markets consistently is very difficult due to the underlying assumptions required for technical analysis to work.
There are a few underlying assumptions required for technical analysis to be effective.
For technical analysis to work, markets must be somewhat efficient. The information shown on charts must include all possible information that affects a stock's current price. Technical analysis relies on people to do fundamental analysis on the companies and then buy or sell the stock in response. Or else, if everyone looked at a chart and kept buying on buy signals and momentum, then there would be no limit to the stock price.
Technical analysis doesn't work as well when markets aren't efficient. For example, when the video conferencing company ZM started trading after an IPO, investors bought up the penny stock with the ticker ZOOM by mistake. If we were looking at the ZOOM charts, the spike in price would not have been explainable or useful for the future.
Specific identifiable patterns such as support bands and bull flags require the assumption of how the stock behaved in the past indicates how the stock will behave in the future. The support is a common term that describes a price point when the stock stabilizes after a sell-off. Technical analysis states that the support is a psychological price floor that investors will stop selling. However, if there is a fundamental change in the business outcome, previous years' support prices will be completely irrelevant. For example, airline stocks after COVID-19 blew past all support lines when they lost 60% in value.
Dark pools are alternative exchanges large institutional investors use to enter or exit big positions. In dark pools, traders do not have access to all information and have no visibility into how many shares are for sale at any time, hence the name dark pools. The data and charts technicians, people who use technical analysis, have access to wouldn't capture the full information of the market sentiment.
Many assumptions do need to line up for technical analysis to work effectively. Yet, this doesn't stop people from trying to time the markets. An emerging investor could spend hours upon hours looking at and trying to read charts and at the end of the day end up being just as wrong as someone who didn't. However, technical analysis is sometimes the only tool available for Forex and commodities trading.