Investors gravitate towards financial markets to generate and protect long-term wealth. Investment strategy is often divided between fundamental and technical camps. Fundamentalists, such as legendary investor Warren Buffett, are more so concerned with underlying business economics and profitability. Technical analysts, or technicians, rely upon statistical data and human psychology to trade stocks and turn profits. Technical analysis, of course, is fraught with its own distinct risks.
Asset Prices and Volume
Technical analysis is based strictly upon asset price and volume data to identify trends to make investment decisions. Volume identifies the number of shares that trade hands during a particular transaction or time period. Abnormally large volume at particular points during a stock’s trading history may be used to confirm financial trends. Bullish trends refer to situations where a certain investment continues to advance in value. Conversely, declining equities exhibit a bearish trend.
The Trend is Your Friend
Technical analysts study asset price charts to determine patterns and trends. Resistance points and support levels are identified as brackets for trends. For example, shares of ExxonMobil may decline towards $80 several times over a six-month period, before breaking out of this pattern and advancing beyond $100. Stock X has established a support level at $80, and technical analysts will buy the stock whenever it nears $80.
Alternatively, Intel appreciates to $40 upon numerous trading sessions, only to decline back into the $25-$30 range, shortly thereafter. $40 is the resistance point, and Intel shares may break down below $25 into a bearish trend. This action signals that investors have grown weary of the stock—refusing to believe that shares will overtake $40. Technical analysts may sell Intel stock short, or purchase put option contracts at a $40 strike price.
Reversals are shifts between bullish and bearish trends. The head and shoulders pattern is a classic reversal example. The head and shoulders chart features one high point as the head, surrounded by two lower, intermediate highs that form the shoulders. The low points within the head and shoulders form a neckline at the stock’s resistance points. Head and shoulders is a transition between a bullish and bearish trend. Upside-down head and shoulders is a bearish to bullish trend reversal pattern. Technicians buy stocks before bullish trends begin to profit.
Technicians are exposed to head fakes, or short-term investment patterns that never materialize into long-term trends. In the aftermath of a stock market crash, share prices may advance sharply for a few days, before deteriorating further into long-term recessionary bear market. Investors who bought stocks during the sharp advance believe that the market was in the beginning stages of a bullish recovery. In actuality, these investors bought into a head fake, or dead-cat bounce. These volatile moves reel investors into large losses.
Technical analysis, again, is not to be mistaken for fundamental analysis. Fundamental analysis takes economic factors into consideration when plotting strategy. Fundamental analysts research sales figures, political legislation, and product lines to purchase stocks at prices that offer strong value and growth potential. Pure technical analysis, however, ignores the economic factors that influence share price performance and business valuations.