Technical analysis is a trading discipline that evaluates investments and identifies trading opportunities by analyzing statistical trends gathered from trading activity, such as price movement and volume.
Understanding technical analysis
Technical analysis operates on the premise that historical trading activity and price changes of a security are indicators of its future price movements. Analysts examine price charts and trading volume data to find recurring patterns. This discipline is applied across various international markets, including equities, commodities, foreign exchange, and fixed-income securities, wherever historical price data is available.
The discipline relies on specific assumptions about market behavior. The primary assumption is that all known fundamental information is already priced into the asset. Analysts focus entirely on the statistical movement of the price itself. A secondary assumption is that price movements follow trends rather than moving randomly. Technicians assume that once a trend is established, the future price movement will follow that trend rather than move against it.
Technicians use different charting tools and indicators to identify these trends. Moving averages smooth out price data to create a single flowing line, making it easier to spot the direction of the trend. Oscillators, such as the Relative Strength Index, help determine if an asset is overbought or oversold. These tools help traders identify support and resistance levels – specific price points on a chart where the probabilities favor a pause or reversal of a prevailing trend.
For Elephants navigating global financial markets, technical analysis provides a mathematical framework for calculating entry and exit points. Because the methodology relies purely on market data, the same technical indicators can be applied to a stock on the Tokyo Stock Exchange, a commodity traded in Chicago, or a currency pair traded in London.
Example
Consider an agricultural commodities market where a company, Elephant Peanut Farms PLC, is publicly traded. An investor wants to buy shares after reading strong crop yield reports. The investor looks at the stock’s price chart to determine when to execute the trade. The investor identifies a “double bottom” pattern on the chart. This pattern occurs when the price drops to a specific level, rebounds slightly, drops back to the same level, and then begins to rise again. The investor observes that trading volume increased significantly during the second drop. Relying on technical analysis, the investor interprets this pattern and the high volume as a signal that the downward trend is exhausted and an upward trend is beginning. The investor purchases shares of Elephant Peanut Farms PLC using the chart pattern to time the entry point.