Overview of Technical Analysis

While fundamental analysis helps you decide what companies you may want to invest in - based on the company's management, products and services, financial records, and other information - it won't always help you figure out when to buy, sell or hold. There will be times when the stock of a solid company falters and times when a riskier company performs well. As a result, although fundamental analysis is important, it's not always sufficient to make investment decisions. Technical analysis, the study of price movements and trends, can help you figure out when to enter and exit the market.

Technical analysis, which gained momentum in the late 1800s as Dow Theory, is one of the oldest techniques used to make market decisions. Based on the ideas of Charles Dow, technical analysts use a variety of technical indicators, or series of data points plotted on a price chart that has been formed using price or price and volume statistics for a particular security over a particular time period. The goal is to spot market trends and manage risks associated with price movements.

While some indicators use complex formulas and others are simpler, all of them seek to establish visual patterns that make sometimes confusing price data easier to understand and interpret. Indicators can be applied to stock, indexes, futures contracts and any other tradable instruments whose prices move in response to supply and demand.

While each indicator depicts patterns made by the price movements of securities, studying just one may not give you a complete picture of the direction the price is likely to head.

For example, an indicator may make false signals, called whipsaws, where prices move in one direction and quickly revert to an original trajectory. Examining more than one study makes it easier to spot true signals.

Furthermore, different indicators measure different variables. For example, the Moving Average Convergence/Divergence (MACD) is used to show changes in price, while Williams %R, Stochastics and Relative Strength Index (RSI) help predict trend reversals. Studying a combination of indicators can help you gain a balanced and inclusive perspective on a security's current and potential price movements.

However, regardless of the indicators you use and how closely you monitor the underlying investment, keep in mind that it's possible prices may not move the way you expected because investing is inherently unpredictable.

What is Dow Theory?

Founded on the writings of Charles Dow at the turn of the 20th century, Dow Theory was further refined by William Hamilton, Robert Rhea and others to form the basis for technical analysis as it's used today.

Technical analysis is based on the notion that you can't manipulate the primary, or major, trend in the market and that market prices reflect all factors that affect supply and demand, such as political and economic events and investor sentiment. Though there may be unexpected fluctuations over the short-term, the long-term primary trend will remain intact.

Proponents of Dow Theory believe that studying prices gives you a meaningful understanding of securities and their movements and trends, and forms the basis for making market decisions.

The strategies described in this article are for information purposes only, and their use does not guarantee a profit. None of the information provided should be considered a recommendation or solicitation to invest in, or liquidate, a particular security or type of security. Investors should fully research any security before making an investment decision. Securities are subject to market fluctuation and may lose value.