Technical analysis, as opposed to fundamental analysis, is the study of market action, primarily through the use of charts. The technician believes that anything affecting the price, such as fundamentally or psychologically, will be reflected on charts. Technicians believe that the market discounts everything and that any news about a company is already priced into the stock. Keep in mind that the charts do not cause market action, but rather, they reflect the actions of the marketplace and what has already happened. However, this does not mean you should not study fundamental analysis, since it is just as important.

Technical analysis is applied social psychology because when you analyze charts, you are analyzing the behavior of traders. Charts reflect trades by all market participants: buyers, sellers, and even insiders. Each price on the charts reflects the actions or lack of actions by all the traders in the market.

Technical indicators help make our analysis more objective as it seeks to recognize trends and changes in crowd behavior so that intelligent trading decisions can be made. Technical analysts study charts to find out whether the bulls or bears are in control. They look at past charts for repetitive price patterns and study to recognize the early stages of uptrends and downtrends.

There are 2 main types of technical analysis: classical and computerized.

1. Classical analysis – This is based only on the study of charts, without using anything more complex than a pencil and a ruler. This is mainly the focus on uptrends and downtrends, support and resistance zones, as well as repetitive patterns, such as triangles and rectangles. Its main drawback is its subjectivity: if you are bullish, your ruler will tend to inch up and likewise, if you are bearish, your ruler will tend to inch down.

2. Computerized analysis – This is more of a modern approach whose signals are much more objective. The 2 main types are trend-following indicators and oscillators. Trend-following indicators include moving averages, Directional System, and MACD (moving average convergence-divergence), which all help to identify trends. Oscillators, such as Stochastic and Relative Strength Index (RSI) help identify reversals.

As you can observe, technical analysis is partly a science and partly an art—partly objective and partly subjective.

But be careful because charts are full of false breakouts, false reversals, and flat trading ranges.

You can argue about trends but technical indicators are objective. Indicators are derived from prices and the more complicated they are, the more they deviate from prices and reality. Therefore, using simple indicators work the best.

The good technical indicators are immune to parameter changes and give useful signals at a broad range of settings. This means that if an indicator you are using gives great signals on a 20-day window for a certain stock but bad ones when you switch to a 15-day window, then the indicator is not too reliable.

Technical indicators can be divided into three major groups:

1)      Trend-following- These indicators include moving averages, MACD (moving average convergence-divergence), Directional System, among others. These indicators help us stay long in uptrends and short in downtrends.

2)      Oscillators – These indicators include Stochastic, Rate of Change, and many more. Oscillators help us identify turning points, or reversals, by displaying when markets are overbought (too high and about to fall) or oversold (too low and about to rise). They work great in trading ranges, catching upturns and downturns. The disadvantage is that they can give premature buy signals in downtrends and sell signals in uptrends.

3)      Miscellaneous Indicators – These indicators include Bullish Consensus, Commitments of Traders, and New High-New Lower Index, which measure the current mood of the market.

The tricky part is that indicators from different groups often contradict one another. For example, when markets decline, trend-following indicators turn down, signaling us to sell but at the same time, oscillators can become oversold and signal us to buy.