To get the most benefit from using technical analysis, you need to understand how it operates and what it is that you’re looking at. Technical analysis is based on the following assumptions.
The price is the be-all and end-all
The premise of technical analysis is that the stock’s market price provides enough information to render a trading decision. Those who criticize technical analysis point out that it considers the price and its movement without paying adequate attention to the fundamental factors of the company.
The argument made favoring technical analysis is that the price is a snapshot that, in fact, does reflect the basic factors affecting the company, including the company’s (or investment’s) fundamentals.
Technical analysts (also called technicians or chartists) believe that the company’s fundamentals, along with broader economic factors and market psychology, are all priced into the stock, removing the need to actually consider these factors separately. The bottom line is that technicians look at the price and its movement to extract a forecast for where the stock is going.
The trend is your friend
The price of a stock tends to move in trends. In the world of technical analysis, the phrase “the trend is your friend” is ubiquitous. Following the trend is a bedrock principle in technical analysis, and the data either supports the trend, or it doesn’t. When a trend in the stock’s price is established, its tendency is to continue. The three types of trends are up, down, and sideways.
If it happened before, it will happen again
Another foundational idea in technical analysis is that history tends to repeat itself, mainly in terms of price movement. The repetitive nature of price movements is attributed to market psychology; in other words, market participants tend to provide a consistent reaction to similar market stimuli over time.
Technical analysis uses chart patterns to analyze market movements and understand trends. Although many of these charts have been used for more than 100 years, they’re still believed to be relevant because they illustrate patterns in price movements that often repeat themselves.