In today’s equities marketplace, the technical analysis of stocks is a popular discipline. Each day, millions of market participants use tools, indicators, and price action as primary decision-making mechanisms.
Read on to learn more about the advantages and disadvantages of stock market technical analysis.
The Technical Analysis of Stocks
Technical analysis is the study of past and present price fluctuations to predict future market behavior. It is a go-to method in the forex, futures, and shares markets. Within the realm of equities, technical analysis helps market participants address volatility in shares, indices, and exchange-traded funds (ETFs) from a practical standpoint.
Of course, you should remember a few important pros and cons when using technical analysis to trade and invest in stocks:
Every type of analysis has unique advantages. The following benefits of the technical analysis of stocks are worth consideration:
When applying technical analysis to stock prices, it’s relatively simple to stay objective. Remember, technical analysis is the study of price action in isolation—no external factors are considered. When a trader buys or sells a stock based on technical analysis, the decision is free of nuance. Past and present price behavior dictate an action. In this way, subconscious, personal, and obscure biases are avoided.
Technical tools and indicators are mathematically based. They are derived from price data using formulae without ambiguity. Although the actual values vary, calculations are based on a structured analytical approach.
For example, assume Trader A is a big fan of the 200-day simple moving average (SMA). Trader A can rest assured that no matter which stock the 200-day SMA is placed on, the value is derived in a standardized fashion. So Trader A’s 200-day SMA technical analysis of stocks is consistent. Regardless of the stock or price, it provides an apples-to-apples comparison of the period’s price action.
A trading system is a structured, rules-based approach to buying and selling securities. It’s a set of parameters that governs every action a trader makes in the market. The objective consistency of technical analysis makes it an ideal foundation for stock investment and trading systems.
No analytical base is free of drawbacks. Here are three downsides of technical analysis:
The technical analysis of stocks indeed promotes consistency and objectivity, but it is also a rigid approach to trading. Regardless of the state of the market, technical indicators continue to produce data and buy-sell signals. This is what they are designed to do, but the odds of creating false signals increase during less-than-ideal trading conditions.
Another downside to relying on technical analysis for crafting trading decisions is hindsight bias. Technical tools are frequently deemed effective or ineffective per backtested results. Unfortunately, backtesting studies often fall victim to pitfalls like data back-fitting, flawed historic data sets, and user bias. With inaccurate backtesting, an indicator may be applied improperly in the live market.
Lack of Fundamentals
Technical analysis does not account for the fundamentals local to the stock market or individual shares. Important economic releases, corporate reports, and external events are all ignored. Key fundamentals can drive long- and short-term volatility in the markets. Although the technical analysis of stocks accounts for enhanced price action, it doesn’t factor in the increased risks posed by evolving market conditions.
Interested in Becoming a Market Technician?
To become an expert in technical analysis, you have to start somewhere. StoneX’s e-book, Technical Analysis for Beginners, is a great place to begin your journey. Before you trade another share of stock, download your complimentary copy here.