What is technical analysis?

Credit: Ken Teegardin

In the share market, broadly speaking, there are two types of investors:

  1. Technical investors; and
  2. Fundamental investors

There are many differences between the two. However, there is one very important distinction dividing technicians from fundamental investors:

Technical analysts forecast the price at which a share will trade, while fundamental investors find the price at which it should trade.

Basically, fundamental investors forecast a price which they believe is the ‘fair’ or ‘intrinsic’ value of the shares. This figure is based on hours, days or even weeks of research into the business. For example, if I was considering buying shares of Woolworths Limited (ASX: WOW), I’d look into its financials, go into supermarkets, talk with store managers and compare it to its peers. Hypothetically, if a fundamental analyst determined Woolworths shares were worth $30, yet they currently traded at $24, they may assign it a ‘buy’ rating with a ‘$30 price target’. It can take years for a share price to reach its ‘fair’ value.

Technicians, on the other hand, do not study a company or its business, and their timeframe for investment is short term. They use charts and indicators to predict share price movements. They use words like “pattern”, “trend”, “resistance” or “support” to describe the relationship between historical share price movements and volume. That means technicians use data to identify trends that are already underway.

So how do technicians try to predict share price movements exactly?

There are many different methods, strategies or theories put into practice. However, most strategies make extensive use of the fundamentals of economics, specifically supply and demand. For example, if there are many more sellers than buyers of Woolworths shares, a downtrend in its share price may emerge because supply is overwhelming demand.

Data sourced from S&P Capital IQ

Data sourced from S&P Capital IQ

You can see in the chart above that each time Woolworths’ share price begun to fall, the volume appeared to increase. Technicians also use charting, usually at short intervals, to predict market prices.

They could compare a share like Woolworths to say, Wesfarmers Ltd (ASX: WES), to gauge relative strength. They may also compare Woolworths and Wesfarmers to the S&P/ASX 200 (Index: ^AXJO) (ASX: XJO).

Moreover, technicians will formulate levels of ‘support’ or ‘resistance’ to describe price levels which may offer a ‘floor’ or ‘ceiling’ for a share price. A support level would be a price which the technician believes makes an attractive investment for that share and could, therefore, be a price at which others are willing to buy.

Many theories have attempted to uncover appropriate levels of support or resistance but they remain intensely subjective.

So what happens when they’re wrong?

Generally, if a share price falls or rises through a support or resistance level it is said that there is a ‘change in popularity’. For example, if Woolworths’ share price fell 5% or 10% below its ‘support’ level, that same support level then becomes a resistance level.

Technicians suggest reversals in trends can predict share price targets. Head and shoulders, inverse double-bottoms and triple tops are examples of patterns used to described reversals. Continuation patterns, like triangles, are used extensively to support a technician’s view that a share price’s trend may resume.

Finally, some technicians believe technical indicators can predict movements in share prices, or markets as a whole, over years and decades! Some technicians even predict that calendar years, such as those ending with ‘5’ (e.g. 2015), are the best years to invest in share markets.

Foolish takeaway

Using technical analysis to try and predict share prices and grow your wealth in the sharemarket is akin to gambling, in my opinion.

Indeed, I know shares are simply part-ownership of a business with services or products people know and use every day. On the other hand, I know the market can be completely unpredictable.

While you may get lucky every now and then using technical analysis (remember even a broken clock is right twice a day) investing in good businesses over the long-term is the surest way to sustainably grow your wealth. Further, I believe conducting research and doing your own analysis is the only way to come even close to determining a fair price to pay for shares.

Sure, prices will rise and fall and you may not get every investment right. But following in the footsteps of investing greats like Warren Buffett – one of the world’s richest people – has enabled many investors to succeed in the sharemarket – without trying to predict what the market will do.

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Motley Fool writer/analyst Owen Raszkiewicz has a financial interest in Woolworths. Owen welcomes -- and encourages -- your feedback on Google+, LinkedIn or you can follow him on Twitter @ASXinvest.

Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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