What is Technical Analysis? (Plain English Definition)
Definition: Technical analysis is the study of past price movements and trading volume patterns to predict future price direction.
Technical Analysis Explained Simply
Technical analysis attempts to forecast future price movements by studying historical price charts, trading volume, and various mathematical indicators derived from price data. Practitioners (called technicians or chartists) believe that all relevant information is already reflected in the price and that prices move in identifiable patterns and trends.
Common technical tools include moving averages (smoothing price data over time), relative strength index (measuring momentum), MACD (identifying trend changes), and support and resistance levels (price points where buying or selling pressure has historically been strong). Chart patterns like head and shoulders, double tops, and triangles are also widely studied.
The effectiveness of technical analysis is heavily debated. Academic research generally finds little evidence that technical analysis consistently produces excess returns after accounting for trading costs. The efficient market hypothesis suggests that any patterns in price data would be quickly exploited and eliminated. However, many professional traders use technical tools as part of their decision-making process, and some patterns do show statistical significance over large data sets.
Technical Analysis Example
A technical analyst notices that an ETF has bounced off the $100 price level three times in the past year -- each time falling to around $100 before buyers stepped in and pushed the price higher. They identify $100 as a support level and decide to buy near $100, placing a stop-loss at $97 in case the support fails. If the ETF bounces again, they plan to sell near $115, a resistance level where the price has previously stalled.
Why Technical Analysis Matters for ETF Investors
Understanding technical analysis helps ETF investors evaluate certain trading strategies and smart-beta products. Some momentum ETFs incorporate technical signals into their selection methodology, and many market commentaries reference technical levels. For most ETF investors focused on long-term wealth building, technical analysis is largely irrelevant. The evidence strongly supports a buy-and-hold approach using diversified index ETFs. However, understanding basic concepts like support, resistance, and moving averages helps you interpret financial news and understand why short-term traders make the decisions they do. It also helps you recognize that market timing based on charts is extremely difficult and unlikely to improve your long-term results.
Technical Analysis vs Fundamental Analysis
| Technical Analysis | Fundamental Analysis |
|---|---|
| Technical analysis is the study of past price movements and trading volume patterns to predict future price direction. | See full definition of Fundamental Analysis |
While technical analysis and fundamental analysis are related concepts, they serve different purposes in the world of ETF investing. Understanding both terms helps you make more informed decisions about which funds to include in your portfolio and how to evaluate their performance.
Related Terms
Deepen your understanding of ETF investing by exploring these related concepts:
Fundamental Analysis
Fundamental analysis is the method of evaluating a security by examining the underlying financial and economic factors that affect its value.
Momentum Investing
Momentum investing is a strategy that buys securities that have been rising in price and sells those that have been falling, based on the tendency for trends to continue.
Efficient Market Hypothesis
The efficient market hypothesis proposes that stock prices already reflect all available information, making it nearly impossible to consistently beat the market.
Trading Volume
Trading volume is the total number of shares of a security that are bought and sold during a specific time period, usually one day.
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