What is technical analysis?

If you flip a coin, there are only two possible outcomes: heads or tails. Therefore chances are even half of the time it will be heads and, tails about half of time as well.

Stocks are not much different: they can either go up or down. They can also move sideways for a period of time, but eventually they'll plunge or go sky high, or do both, given enough time. From a mathematical point of view, we can examine a stock just like the flip of a coin. The theoretical construction supporting this way of thinking is called a mathematical (or more precisely, statistical) model. Technical analysis is an abstract logic layer, a methodology for predicting the outcome of flipping a coin – or buying, holding or selling stock. Technical analysis relies on theorems and deductions; data gathered from examining stock price fluctuations for many years as well as the statistical correlations between certain events and stock price action. For example, a reverse split (for example 4 "old" stocks for 1 "new") is usually considered an unfavorable event, although on paper, it shouldn't have any kind of impact, as the underlying company's financial status is for all intents and purposes unchanged. But still, looking at numerous charts will convince anyone that the statement holds true most of the time. Why that is, is not something technical analysis is concerned with.

At its purest form, technical analysis contends that based on past observations, future price action can be predicted, to a certain, statistically meaningful degree, without aid from external sources, such as fundamental analysis, for example. The predictive tools used for that are called leading indicators, and a significant group in this category consists of momentum oscillators, such as the Relative Strength Index (RSI), the Stochastic Oscillator or the Commodity Channel Index (CCI). On the other hand, lagging (or trend following) indicators help us understand what is happening during strong trends, and usually don't lead prices. Such indicators include the various moving averages and the MACD (Moving Average Convergence/Divergence)

All the information technical analysis needs for any given stock or asset, is the chart. It is a graphical representation of price action during a selected period of time. The chart may contain just the closing price, or be more detailed (open, close, high, low). There are four main types of charts: line, bar, candlestick and last but not least the point and figure charts.

But the holy grail of technical analysis is the trend – the general direction in which the commodity, stock or market is headed. The possible directions are again either up or down, with periods of indecisiveness, when prices fluctuate with no apparent conviction ("trend"). An uptrend is a series of of new higher highs, whereas a downtrend is a series of new, lower lows. If we cannot see a clear up- or downtrend, we have prices moving sideways. Prices usually move in a channel between the high and the low trendlines.

We use all of the tools and methods provided by technical analysis to identify the trend. Trades in the direction of the trend are usually profitable and in fact the more time our trade is consistent with the trend, the more profitable it becomes. In fact the trend is not only positively, but also negatively important: in the long run, you need not only embrace the trend, but also not fight it in any way whatsoever. If you go short in an uptrend, you will get burned, unless you nail the reversal point – the point where an uptrend, for example, reverses its course and converts to a downtrend. Don't count on nailing this point often though; after all, it is a lot easier to follow the herd, than point out exactly where or when it will take a turn!