When Is Technical Analysis a Good Idea?

Technical analysis is a mathematical, logical process applied when evaluating stocks and other assets for possible investment. Though individual tactics within technical analysis exist, the overall idea is to look at historical patterns and trends, make forecasts, and predict how the asset’s price will change in the future. For example, you might examine an asset’s price trends, moving averages, volume, open interest, or momentum indicators. The basics are easier to learn than you might think, and experienced investors can spend a lifetime diving into new and exciting analysis methods.

But is technical analysis a reliable way to evaluate the potential of a given asset? And if so, how should the average investor implement it?

Advantages of Technical Analysis

There are a number of key strengths in the technical analysis approach:

• Objectivity. Any experienced investor can tell you that making emotional or biased decisions is a recipe for disaster; if you sell because you’re afraid of loss or buy because you’re excited about a potential profit, you’ll eventually lose. Technical analysis takes emotion out of the equation. In most cases, you’ll input numbers into a formula, and get a specific, numerical response—with little to no room for subjective interpretation. This can halt a number of emotional decisions before they happen.
• Consistency. Technical analysis is also a method that can be employed consistently, with tremendous reliability. Though you might have a different entry point than your peers, once you establish the parameters for what counts as a “good” investment decision, you can apply those criteria to all your decisions, and ensure your strategy is executed consistently. Even if it doesn’t work, you’ll get valuable information about how your tactic performs, and you’ll be able to adjust your approach accordingly.
• Availability of tactics. There’s also no one way to employ technical analysis; in fact, there are dozens of different chart types, patterns to track, and potential indicators to follow. This affords investors a great deal of flexibility; some investors might prefer to focus on volume indicators, while others focus on average directional price movements. While you should spend a little time on every technical analysis technique, you can eventually gravitate toward a handful of indicators that best suit your preferences and your strategy.

Disadvantages of Technical Analysis

However, there are also some weaknesses to keep in mind:

• Time to learn. Technical analysis is hard to learn, even for already-experienced investors. Each technical factor can be learned in its most basic form in the span of an hour or less, but it takes weeks, if not months of consistent practice before you can truly learn how to use them. On top of that, there are dozens of factors to learn, and you’ll need to spend time learning how each of those factors plays into the others. Even a quick study can spend months trying to master technical analysis without truly becoming a master.
• Historical unreliability. Most technical analysis-based trading strategies operate with the premise that what has happened in the past will continue to happen in the future. For example, if 90 out of 100 stocks with a certain momentum and trading volume performed well in the past, it’s incredibly likely that your current candidate with the same momentum and trading volume will perform well in the future, right? This isn’t necessarily the case. If the stock market were inherently predictable, algorithms would have mastered the art of investing by now. Technical analysis can certainly help you understand the nature of a given asset, but it can’t perfectly predict its future.
• Ignorance of fundamental analysis. If technical analysis has an opposite counterpart, it’s fundamental analysis. Fundamental analysis is the study of a company or asset’s intrinsic value; for example, regardless of technical indicators, a company may be worth investing in if it has a strong brand history, an inspiring leader, and a vision for the long-term future. Because technical analysis studies only objective, measurable factors, it ignores these more subjective—but still important—components. You might overestimate the potential of an asset with strong momentum, but with a weak brand culture and less-than-promising leadership.

When Is It Best Used?

So when is technical analysis best used?

If you plan on day trading or otherwise trading stocks in relatively rapid succession, technical analysis is a practical necessity; it’s the best way to explore patterns in historical data and make predictions about the short-term future of an asset. However, technical analysis isn’t exclusively useful in day trading; it’s also commonly employed as a way for long-term investors or fundamental investors to confirm their suspicions, or find a good entry or exit point.

Overall, technical analysis is a valuable technique to use when choosing assets to buy and sell, but it has too many weaknesses to be used alone. Use it as part of a suite of different trading strategies, including fundamental analysis, for best results.

This article does not necessarily reflect the opinions of the editors or management of EconoTimes