How Technical Analysis Predicts Price Changes

The majority of investors and traders use a combination of fundamental analysis and technical analysis to predict stock price movement. There are day traders who rely only on technical indicators. Their rationale is that the market takes all fundamentals into consideration when coming to the price of any given stock or index. Thus, a trader can use indicators that simply “read” price movement and generate information that can reasonably guide trading decisions. Here are a few thoughts on how technical analysis predicts price changes.

How Technical Indicators Work

To the extent that virtually every trader and investor is tuned into fundamentals and market sentiment one can read the market by how prices change. It is a fact that since everyone is following technical factors they are trading one another’s reactions to the market. Thus, the trader who gets a more accurate reading of these factors and responds more rapidly and precisely is more likely to make a profit.

How Moving Averages Predict Price Trends

An almost universally used indicator in trading is the moving average. This indicator provides perspective in that it averages out daily price fluctuations. A general rule of thumb is that when prices are above the moving average there is an uptrend and when they are below the moving average there is a downtrend. Because moving averages come in different lengths, one may be up while the other is down. This can create “no man’s land” scenarios in reference to trench warfare in the First World War. We often note that this is the case when a stock or index price lies between the 100 and 50-day moving averages. Also, as a rule, when a stock price moves through a moving average with a bit of “air speed” it is a breakout and will keep going up or down to establish a new trend. When the price pauses or retreats it is an indication that the stock or index is still stuck in its range and may even retreat back the other way.

A Disadvantage of the Moving Average (and all technical indicators)

Moving averages are a compilation of past price data. They are helpful to the extent that the market follows its usual course of ebb and flow. But, the moving average, and all technical indicators, has no ability to predict the future. That is why we, and most traders, keep an eye on the news. We repeatedly talk about the DRINCs which are Democrats, Russia, Iran, North Korea, and China. Although the market pays attention to these, it can be a bit slow. Thus, reports of a new strain of Coronavirus in China does not affect the market until infections have spread across the world and the World Health Organization declares a pandemic. Then all of the technical indicators that predicted the rise or fall of XYZ stock go into the waste basket as this single fundamental causes markets everywhere to crash.

Best Use of Technical Analysis

As one can see (and hear) when watching our videos or in our live sessions, we follow the S&P 500, for example, and trade based on very short term market movements. A recent example was the fiasco with Kodak and insider trading. This approach requires a knowledge of the fundamentals involved. The price of Kodak was likely to go up and then plunge when knowledge of insider trading surfaced. And, it requires a close eye on technical indicators in order to time trade placement and determine where to set strike prices and when to set expiration date. In some cases it requires that you carefully watch the trade in order to avoid loss and maximize profits and in other cases such as with the bear call spread we so commonly use, it only requires that you set up the hedged trade before going the beach!