There are two major methods for analyzing stocks. One method is Fundamental analysis and the other is Technical analysis. Fundamental analysis analyzes demand and supply of a stock. It tries to explain why a price moved the way it did, and it is based on current demand and supply.
Technical analysis is based on historical data. It can almost be described as identifying patterns, and applying the rules derived from the patterns to future price/volume movements. Technical analysts do not care about the why, they hope to predict price movements based on patterns. These patterns are usually derived from charts created from historical data. The formal definition is “Technical analysis is the study of market action, primarily through the use of charts, for the purpose of forecasting future price trends”[i].
There are three key assumptions in technical analysis.
- Market price movements reflect all factors
2. Prices move in trends
3. History repeats itself
Technical analysts believe that market price movements reflect all factors such as supply, demand, political, and psychological. This assumption lets them focus only on price movements , they do not have to worry about the individual factors itself, it should be reflected in the price movements.
The analysts also believe prices move in trends, and history repeats itself, this is why they use past trends using historical data to predict future movements. These three assumptions form the basis of technical analysis.
[i] Technical Analysis of the Financial Markets, John J. Murphy