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What is technical analysis - Part 1

Saxo Be Invested

Saxo Bank

Summary:  Before buying a stock, it is important to make an analysis to justify your decision. There are various types of analyses you can use with the most popular being fundamental and technical analysis. While fundamental analysis answers, the question "What should I buy?", technical analysis answers "When should I buy?"

Technical analysis focuses on timing. It comes in two variants: visual and statistical analysis. The visual form involves studying charts of historical stock prices. The statistical method, on the other hand, entails making calculations based on a series of historical stock prices. In either case, the goal is to identify the most likely price trend – i.e., is the stock most likely to go up, down or sideways? It's worth noting that technical analysis does not guarantee 100% predictive accuracy. Instead, it should be seen as a risk management tool, aiming to minimise risk in an investment.

Technical analysis: A deeper Look

Technical analysis is rooted in three main principles:

  1. All available information is reflected in the share price.
  2. Share prices move in identifiable trends.
  3. History tends to repeat itself, or at least often rhyme.

The first principle relates to how investors process information. Whether it's a profit warning or the launch of a new product, investors evaluate how it will affect the stock price, resulting in either a buy or sell order. In short, the stock price is dictated by supply and demand.

The second principle involves understanding trends. When a technical analyst discusses 'prices moving in trends', they are referring to three possible price movements for a stock: a fall, a rise, or a sideways movement. Downward movements are identified by consistently lower lows and lower highs, whilst upward movements are recognised by increasingly higher highs and higher lows. A sideways market occurs when a stock price moves within a set horizontal range.

The final principle, 'history repeats itself', is about investor behaviour. Regardless of the trigger, investors often respond similarly in similar situations, driven by fear and greed. For example, during the dawn of the internet era, many desired to own shares in internet companies, believing the internet would revolutionise the world. This led to a price bubble. As the initial investors started selling, prices began to fall, and widespread panic ensued, where many sold again and prices fell sharply.

Historical perspective on technical analysis

Japanese rice traders attempted to chart trends as far back as the 17th century, but technical analysis only truly gained traction with the advent of the personal computer. Charles Henry Dow, founder of The Wall Street Journal, along with Edward Jones, the namesake of the Dow Jones index, published numerous findings about price movements in the US stock market in their newspaper around 1900. Dow frequently utilised charts in his analysis.

In conclusion, technical analysis is about optimally timing investments. It involves two main types: visual and statistical analysis. The visual form focuses on the study of price charts, whereas the statistical method centres around price calculations. Both aim to predict the most likely price movement."

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