🎯 In 30 seconds: Technical analysis is the habit of reading a market’s own record of trades, mainly price and volume, to judge which outcomes are more likely and where an idea would be proven wrong. It rests on three working assumptions that are useful but debatable. It can help with timing, risk and focus. It cannot see news before it happens, tell you what a business is worth, or turn a guess into a sure thing.
A working definition
Every trade leaves a trace: a price, a size and a time. Put enough of those traces on a grid and you get a chart.
Technical analysis is the practice of reading that record. The goal is modest. You are trying to answer three questions about a market right now.
- What is price doing? Rising, falling or going nowhere, and on which time frame.
- What would change my mind? A price level that, if crossed, says the current read is wrong.
- How much could I lose if I act? The distance from where you would enter to where you would admit the mistake.
Notice what is missing from that list. There is no “where will the price be next month.” Chart readers who last tend to think in odds and exits instead of forecasts.
The three assumptions underneath
Most chart reading leans on three ideas. Each one is partly true, and you will use the tool better if you know where each one bends.
1. The trades carry information. The idea is that price reflects what buyers and sellers know, fear and expect, because those beliefs only count once someone places an order. The weak spot: some of what moves price is plain noise, like a fund selling to meet withdrawals. The chart cannot tell you which trades were informed.
2. Prices move in swings, and swings sometimes persist. If prices were a pure coin flip, a chart would hold no useful pattern. Research suggests prices are close to random over short spans but show some persistence over months, which is the momentum effect described by Jegadeesh and Titman. The weak spot: that persistence is small, uneven and easy to overrate on one stock.
3. People react to similar situations in similar ways. Fear near a fresh low and regret after a missed rally look much the same in every decade. The weak spot: when a reaction becomes widely known and traded, it tends to weaken.
What a chart can and cannot tell you
| A chart can show you | A chart cannot show you |
|---|---|
| Which way price has been moving, and how steadily | Whether the company is cheap or expensive |
| Price levels where buying or selling showed up before | Next quarter’s earnings or a surprise announcement |
| Whether trading activity is rising or drying up | Who is buying, or why |
| How far price usually moves in a day or a week | Whether a past pattern will repeat this time |
| A logical place to define your risk | A guaranteed exit price, since gaps can jump past any level |
Many beginner losses come from asking a chart a question from the right column.
How it differs from fundamental analysis
Fundamental analysis asks what a business is worth: its sales, profits, debts and prospects. Technical analysis asks how the market is treating the shares right now.
The two can disagree for long stretches. A sound company can fall for a year, and a weak one can rise on hope. Plenty of people use both: fundamentals to pick what to own, and the chart to decide when and how much. The other course on this site covers the business side in its fundamental analysis chapters, under Stock Market Trading.
The right edge problem
Patterns look obvious on the left side of a chart because you already know how they ended. The only part that matters for a decision is the right edge, where the story has not finished.
That is why this guide keeps asking you to write rules before you look. A rule written in advance is a test. A pattern spotted afterwards is a story.
Where it helps
- Timing. If you already like a stock for other reasons, the chart can help you avoid buying into a fresh slide.
- Risk. A chart offers natural places to say “I was wrong,” such as below a recent low. That turns a vague worry into a number you can size a position around.
- Focus. Scanning charts for unusual volume or new highs is a quick way to find what deserves a closer look.
- Discipline. Written chart rules can be tested and improved. Gut feelings cannot.
Where it fails
- News shocks. An earnings miss, a lawsuit or a takeover offer can move price far beyond any level on the chart, often overnight.
- Thin markets. In shares that trade rarely, a few orders can draw shapes that mean nothing.
- Too many tools. Pile on enough indicators and one of them will always agree with what you already wanted to do.
- Costs. Many signals look profitable before commissions, spreads and slippage, and ordinary after them.
What careful research has found
The evidence is mixed, and it depends on what is being tested.
- Brock, Lakonishok and LeBaron (1992) tested simple moving average and trading range rules on a century of a U.S. stock index and found the signals carried some information.
- Sullivan, Timmermann and White (1999) asked how many rules had been tried to find those winners. After adjusting for that search, the best rule did not hold up well in later years.
- Lo, Mamaysky and Wang (2000) taught a computer to find classic chart shapes and found some of them were linked to modest changes in what returns followed.
- Park and Irwin (2007) reviewed many studies. More of them reported profits than losses, but many had weaknesses such as testing too many rules or leaving out costs.
A fair reading: some chart-based ideas have shown small edges in some periods. None of them is a sure thing, and the edge is easy to lose to costs and to your own mistakes.
How this guide is laid out
The Foundations chapters cover the raw material: price bars, volume and market structure. Later chapters add levels, indicators and patterns, and the last group turns them into a trade plan and an honest test.
- What three questions does chart reading try to answer? Answer: What price is doing, what would change your mind, and how much you could lose if you act.
- Name one thing a chart cannot tell you. Answer: Any of: what the business is worth, upcoming news, who is buying, or whether a pattern will repeat.
- Why can a rule that tested well still disappoint later? Answer: It may have been the lucky winner among many rules tried, and costs can erase a small edge.
- What is the right edge problem? Answer: Patterns look clear in hindsight, but every decision is made at the right edge, where the outcome is unknown.
Sources
- John J. Murphy, Technical Analysis of the Financial Markets (1999)
- Robert D. Edwards and John Magee, Technical Analysis of Stock Trends (first published 1948)
- Brock, Lakonishok and LeBaron (1992), “Simple Technical Trading Rules and the Stochastic Properties of Stock Returns,” Journal of Finance
- Sullivan, Timmermann and White (1999), “Data-Snooping, Technical Trading Rule Performance, and the Bootstrap,” Journal of Finance
- Lo, Mamaysky and Wang (2000), “Foundations of Technical Analysis,” Journal of Finance
- Park and Irwin (2007), “What Do We Know About the Profitability of Technical Analysis?” Journal of Economic Surveys
- Jegadeesh and Titman (1993), “Returns to Buying Winners and Selling Losers,” Journal of Finance
- David Aronson, Evidence-Based Technical Analysis (2007), further reading