Benefits and Limitations of Technical Analysis

20 January 2021 by Traders 360
Benefits and Limitations of Technical Analysis of Stock Charts.

With all the data now at your disposal, studying a stock chart in depth and understanding herd psychology can be useful for your investing approach. In this article, we will present the features of technical analysis as well as the limits on what it can do.

Contrary to fundamental analysis, interpreting share price charts does not take into account the financial health of companies. Technical analysis in itself is not the most suitable method for long-term investing. Studying charts is more useful for determining the optimal price for buying or selling over a shorter period of time and using a momentum-based approach.

Psychology at the heart of investing

The appeal of technical analysis lies in how users can interpret charts in order to better understand herd psychology. Bullish and bearish trends are phases of momentum that are generated by the general investor mood toward a company or industry. In other words, a strong rising movement in the share price is often a reflection of a sense of optimism and excitement on the part of the market. The opposite is also true. A stock with a downward trend reflects a pessimistic perception and puts pressure on sellers. As long as there is no change in attitude, the trend should not reverse.

The same principle more or less applies when addressing the concept of support and resistance zones. These horizontal lines on a chart are an effect of market "memory" and herd perception. With technical analysis, psychological price levels at which many investors decide to buy or sell can be identified. For example, traders may place some emphasis on an all-time high, because the share price has never risen higher. Following this logic, investor perception may be influenced by observation of past data.

The benefits of technical analysis

When analyzing the chart, you place more importance on herd psychology (the market) than on the valuation of a publicly traded company. In fact, this is one of the advantages of technical analysis. To properly read the chart, you don't need to have any particular knowledge of economics, finance or accounting. Indeed, this type of analysis ignores fundamental data and focuses your attention on fluctuations in the share price as well as on trading volume. Understanding and applying technical analysis has nothing to do with your ability to assess a company's financial health.

Another advantage of interpreting charts is that this practice allows you to identify buy and sell signals in order to improve the timing when you take positions. Technical analysis can be more effective than fundamental analysis in determining the best time to buy or sell a stock. For example, using different financial ratios, fundamental analysis can help you determine whether a publicly traded company is undervalued or overvalued by the market. On the other hand, reading this accounting data does not really allow you to anticipate where the share price is headed over the short term. 

Technical analysis is not a crystal ball

There aren't actually any secrets behind studying charts. Technical indicators such as MACD, RSI and the stochastic process only use mathematical formulas to display data that you can interpret as signals. In addition, all lagging indicators provide buy or sell signals with a certain delay in relation to actual price changes. In such a case, you can infer that they serve more to confirm a movement rather than to predict it. 

Figures used by chart specialists such as the "ascending triangle" or the "double top" are figures that appear within a chart and are a visual representation of the phenomenon of pressure on buyers or sellers. These figures recognized by traders also work, in part, due to the phenomenon of self-fulfilling prophecies. In other words, if there are a large number of investors who position themselves based on charts from these specialists, these same people have an influence on the price and can make the expected result come true.

As you can imagine, there is no algorithm that allows you to use the past to predict future movements in the share price with certainty. This is why technical analysis is not infallible and it is important to be aware of its limitations. Basically, it is still possible that, even if all indicators converge to provide you with buy signals, the share price could continue to fall. 

Conclusion

In conclusion, technical analysis allows you to act according to price changes and take advantage of strong fluctuations by recognizing trends, price levels and figures. The main advantage of studying charts is that they can help you better determine at what price it might be wise to open or close a position.  Remember, however, that this type of analysis has its limitations and is not always 100% effective. In the end, do-it-yourself investors can always use a combination of fundamental and technical analysis before making the decision to buy or sell a security.

Author biography: Alexandre Demers has been an active investor since 2013 and is the founder and president of Traders 360 Inc. He has also authored the e-book “Investir à contre-courant” (Investing against the grain) and hosts the “Finance 360” podcast available free on Spotify and iTunes. His goal is to make stock trading more democratic and educate the public at large about the possibilities of self-managed investments.

The above article was written by Traders 360, an independent external firm partnered with National Bank Direct Brokerage.

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