Lesson Data analysis

Technical analysis

Learn how to work technical data analysis into your strategy to help inform your investment decisions.

banner-man-checking-charts-on-computer

The easiest way to describe technical data analysis is to use the context of fundamental data analysis: anything that isn’t fundamental data can be classified as technical data.

Technical data analysis doesn’t look at earnings reports, and it’s not concerned with either a company’s inherent value or its industry’s current economic condition. Instead, technical analysis focuses on statistical data, such as price movements, trade volumes, and other historical data, and looks for patterns that might predict future movements.

Since technical analysis deals with price movements and not the underlying securities, it’s generally considered to be a way to identify ideal entry and exit points for trades, as opposed to fundamental analysis, which is generally considered a way to identify long-term value. However, despite its reputation for being associated with fast-paced trading, understanding technical analysis can be useful in slower-paced fundamental-focused strategies as well.

Technical analysis relies on three assumptions:

  • Market action discounts everything. This one line is the foundation upon which technical analysis was built, and is the mantra for the technical-analysis-only philosophy. It means that every piece of information available through fundamental analysis is already priced into the market. Even if you believe that value-priced stocks exist, technical analysis still assumes that price movements are at least partly dictated by investor behaviours and market reactions.
  • Prices tend to move in recognizable trends or patterns. Technical analysis is all about looking for patterns to see warning signs about a stock’s movements. This would not be possible if price movements were always entirely random or unpredictable.
  • These recognizable trends or patterns repeat themselves. Warning signs are worthless if they only work in hindsight. Technical analysis assumes that predictive patterns will sometimes–not always–predict price movements.

Technical analysis and “Behavioural Finance”

If technical analysis isn’t concerned with what a business does, how it’s run, what’s going on with its industry, or even its true value, then what is it actually measuring?

One way to answer this question is to say that it’s measuring how investors react to specific market conditions, attempting to predict when investors will act based on emotional biases such as optimism, greed, fear, or panic. In fact, many patterns are associated with a specific psychological reaction to price movements.

For example, the “Cup-and-handle” pattern is meant to represent investors getting nervous and hesitating in the middle of a recovery, causing a short-term-but-temporary drop in share price:
cup-and-handle-explainer
It’s important to remember that the above assessment, and behavioural finance as a whole, is merely an interpretation of technical data analytics, and may be seen as a convenient tool to attempt to interpret and explain recurring trends and patterns.

Technical analysis and charts

Since technical analysis deals almost exclusively with data-over-time, it tends to lean heavily on charts. In fact, the candlestick charts that have become synonymous with the stock market are a technical analysis charting tool, and are meant to show patterns that are said to be commonly correlated with future price movements, potentially indicating shifting momentum.

In addition to the recognizable candlestick charts, there are a wide variety of technical analysis tools built into the Questrade Edge platforms which analyze a number of different statistics and moving data points related current and historical trading data. You can learn more about the specifics in our Introduction to charting and Advanced charting and studies lessons.

What technical analysis is (and isn’t) meant to tell you

Technical analysis looks at many different types of data, but its main goal is to identify signs of continuations and deviations, meaning signs that the data you’re looking at will continue doing what it’s doing, or if there are signs that it’s going to change its behaviour.

There are a number of ways technical analysis tries to do this, for example:

Chart with resistance bands
Supports (bottoms) and resistances (tops) - Supports and resistances represent the highs and lows that you would see in a security’s standard price fluctuations. You can think of them as a floor and ceiling of expectation, and can be read in a number of ways–for example, if they’re converging then it may indicate a momentum change when they meet, or if they’re parallel it may suggest steady momentum.
chart-candlestick
Candlestick patterns - Candlestick charts use shapes to represent the highs, lows, opens, and closes for a security’s price over a period of time. Many technical analysts use the shapes of these candlesticks to identify movements, for example, if you have several red (downward) candlesticks in a row followed by a tiny green candlestick in the middle, candlestick theory suggests that downward momentum is beginning to stall out.
chart-momentum-indicators
Momentum indicators - There are a number of data types that are said to identify the trending direction of a security’s price, as well as the strength of that trend. For example, the moving average (which compares the current performance of a security to its average over a certain period of time) is commonly used as a momentum indicator.
chart-RSI
Relative strength indicators - While technically momentum indicators themselves, technical tools like relative strength indicators are meant to compare recent performance to past performance in an attempt to predict if the security is either over-bought (meaning investors are due to sell and lower the price) or over-sold (meaning investors are due to start re-buying and raise the price).
Like fundamental analysis, technical analysis can be either top-down or bottom-up. Top-down technical analysis is primarily concerned with identifying macro-trends before closing in on a sector of interest, then an individual security, whereas bottom-up starts with an individual security and uses macro-trend data points to offer additional context to the data.

As with fundamental analysis, the top-down vs bottom-up debate has no clear objective winner, and it’s up to the individual investor to determine which analysis strategy best suits them.

Technical analysis patterns

Technical analysis has a lot of patterns meant to predict a lot of factors, and many are very specific in their application. For example, the moving average crossover strategy is meant to help identify ideal buy and sell points in volatile securities by looking out for changes in momentum, whereas patterns such as head and shoulders or the above-mentioned cup-and-handle are meant to look at movements, not momentum, to identify whether any stock is likely to rise or fall.

With technical analysis, understanding why the patterns are said to be making the predictions that they are is more important than simply being able to identify the pattern in a chart, especially when charts with similar patterns could have different outcomes. 

For example, the head-and-shoulders pattern is meant to represent a reversal into a price decline:
pattern-head-and-shoulders
…whereas the cup-and-handle is meant to represent an impending climb:
pattern-cup-and-handle
…however, if we look at the two examples side-by-side and cut them off before the actions resolved, they can look very similar:
Some patterns look similar before they play out
In this instance, understanding what the cup-and-handle and head-and-shoulders actually represent would make you more likely to determine which of the two conflicting interpretations of the shape is most likely to play out, and having a comprehensive understanding of what each specific strategy is meant to measure can make sure that your method of interpretation is appropriate for the data you’re interpreting.

Stay tuned for upcoming articles that take a more detailed look at identifying and understanding specific technical analysis patterns and strategies.

Risk-free ways to test your technical analysis strategies

With the huge amount of available data and moving parts involved in technical analysis, there’s bound to be some trial and error. If you’re new to technical analysis, it can be a good idea to test and develop your technical analysis skills in a way that won’t put your money at risk.

Backtesting

Backtesting can be a zero-risk way to test your technical strategy by looking at old data to see if it would have accurately predicted what followed. Studies that can be used to look up historical data on any listed stock are available for free to all Questrade customers.

If you’re planning on using backtesting to test a strategy, you will want to be mindful of confirmation bias. Confirmation bias means looking for data that behaves the way that you think it should, and ignoring any data that would disprove your theory. Remember: the main advantage of backtesting is that it gives the strategy the opportunity to fail without any repercussions. When backtesting, you should also be trying to find the instances when the strategy would not have worked, and seeing if you can identify the reasons why.

Please note: backtesting uses historical data or hypothetical data and not actual data. Actual data or returns may have different results. Therefore, use caution with backtesting data.

Paper trading

Backtesting can be a helpful way to apply hindsight to a technical strategy, but it does have its limitations. If you’d rather test in a live simulation, you may want to try using a simulated account (also known as paper trading) as a risk-free testing ground.

Paper trading lets you test your technical strategies in a real-time simulated trading environment, which can eliminate some of the biases that might skew your backtesting.

There are several platforms that offer free stock market simulators, including our partners at TradingView.

Educational resources and webinars

Technical analysis has been a topic of study and practice for centuries. There have been a lot of extremely gifted minds who have studied and developed different theories and techniques, so there is a lot of information out there you can use to build and refine your own strategy.

Articles like this one can be a good starting point, and you can check out more with lessons such as Introduction to charting, Introduction to studies, and Advanced charting and studies. You can also take a look at our Introduction to technical analysis on-demand webinar, presented by TMX.

In addition to our learning centre, there are countless books, websites, videos, and courses out there that can help you to understand technical analysis and different ways to interpret data. As you conduct your research, please be mindful of the source of the data, and always be cautious about anything that claims to be “foolproof” or that has “get rich quick” promises.

Some warnings about technical analysis

There are a number of things to keep in mind when making investment decisions based on technical analysis, as well as criticisms about relying too heavily on technical analysis alone, such as:

  • Charts can be misinterpreted. As we can see in the head-and-shoulders/cup-and-handle example above, interpreting chart data isn’t exactly a black-and-white science. There is significant room for interpretation in analysis, and even the best technical-focused traders mis-read data from time to time.
  • Trends aren’t guarantees. An identifiable trend is meant to give investors a sense of the likelihood of a certain set of results, not to give an absolute prediction. Ideally a technical strategy will give you a set of outcome probabilities, but there is no guarantee that the strategy’s suggestions will match the actual outcome.
  • Technical analysts may ‘trick’ each other. There are a lot of very active traders who use technical analysis to guide their investment decisions, and those traders can sometimes be enough to skew the outcome towards an incorrect pattern. For example, if the patterns for a certain stock suggest that the price is about to drop, technical analysts may begin to sell their shares, which will drive down the price in the short-term, even if the stock price is otherwise in the midst of a long-term upward trend.
  • Technical trends are often contradictory. Technical patterns don’t exist in a vacuum, and different data points could point at completely different outcomes. For example, you may have a pattern like the cup-and-handle that indicates that the price is climbing, but a relative strength indicator telling you that it’s over-bought and that its price is due to fall.
  • Some technical strategies require advanced data packages. While Questrade provides free real-time streaming data, some technical analysis methods require information such as trading volume and time & sales data that is only available with a Level-2 data package or, if you’re options trading with Level-1 data strategies, a real-time options package. While data packages can be very helpful in technical analysis, and they are available for free if you hit certain trading volumes, the benefit may not be worth the cost if you don’t trade often enough to get your money’s worth. Learn more about available data plans.

While technical analysis does have its critics, understanding the principles behind various technical strategies can help to make you a more well-rounded trader, even if you don’t plan on using technical analysis as the primary basis of your own strategy. As with all things in investing, it’s important that you do your own research, consider what you learn within the context of your investing goals, and determine for yourself which elements best suit your own investing strategy.

Available technical analysis tools

Questrade has many tools to help you find the technical data you’re looking for, including:

The Morning Brief

Prepare yourself for the trading day with this daily newsletter featuring news and perspectives around the market. Sign up to The Morning Brief through your web portal by choosing Market Research from the drop-down navigation and selecting Newsletters > Morning Brief:

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Intraday Trader

Intraday Trader is your personal algorithmic technical analysis tool with customizable watch lists, searchable technical patterns, and regular updates on identified patterns throughout the trading day. Plus, Intraday Trader includes an educational area to help you learn more about technical analysis.

You can access the Intraday Trader through the web platforms by going to Market Research > Intraday Trader, or through Edge Desktop through either the Research icon or through Tools > Research in the top menu.

Edge Desktop advanced charting and technical studies

The Edge Desktop platform features an array of advanced charting tools and technical studies. You can learn more about what they are and how to use them in our Advanced charting and technical studies article.

Note: The information in this blog is for educational purposes only and should not be used or construed as financial or investment advice by any individual. Information obtained from third parties is believed to be reliable, but no representations or warranty, expressed or implied, is made by Questrade, Inc., its affiliates or any other person to its accuracy.

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