What is Technical Analysis? Explain It Like I’m Five

by Chris Von Wilpert, BBusMan • Last updated January 13, 2024

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What is technical analysis?

Technical analysis is a method to make predictions about price movements of financial assets, based on historical market data. Traders use technical analysis and indicators in order to find repeating patterns make trading decisions.

Technical analysis fast facts

  • Some traders believe that technical analysis can predict future movements of financial assets.

  • There are many patterns and indicators, which makes technical analysis hard on beginners.

  • AI trading apps do technical analysis and use the data to send order signals to traders.

  • Technical analysis is not the only method to make trading decisions.

  • Learning technical analysis requires time, but the effort is worth it for anyone who is serious about trading.

Technical analysis presents data of securities in visual charts that give traders an instant overview of the historical price evolution. Photograph: TradeIdeas

What are the two main types of technical analysis?

Technical analysis uses data of prices and volumes of securities and provides information to traders in two ways: chart patterns and technical indicators. 

Chart patterns are shapes on price charts, like pennants, flags, triangles, rectangles, cup and handle... Traders interpret these patterns as signals for future price movements.

Technical indicators are mathematical formulas that analyze price and volume data. Examples of technical indicators are the moving average, the relative strength index (RSI, the Bollinger Bands, the Aroon indicator, the Ichimoku cloud, the average directional index, and so on).

What is the golden rule of technical analysis?

The three core principles of technical analysis are often referred to as the golden rule. For starters, technical analysis assumes that the current price of a security is based on all available information and that this is enough to make informed trading decisions.

The second principle is that it uses data from the past about the price and volume of financial assets. This data reveals patterns and contains indicators for future price changes. 

The last principle is that history repeats itself. Traders believe that patterns and indicators can reveal in which direction the prices will move.

What is an example of technical analysis of a stock?

Traders that do a technical analysis of a stock, can, for example, do the following steps:

  • A trader identifies the overall trend of the stock price. It can go up, down, or sideways. Technical analysts usually consider upward trends as buying signals and downward trends as selling signals.
  • The trader can then identify so-called support and resistance levels. Support levels are price points on a chart where buyers usually step in. Resistance levels suggest the opposite, and it can be a sign that the price will decrease or remain the same.
  • Chart patterns are used to predict future price movements and can reveal opportunities to buy or sell. 
  • Technical indicators can give more insights, but it is up to the trader to choose the ones they believe are the most reliable.
  • A trader can use all the insights of a technical analysis to make a trading decision and buy or sell the stock.

What are the pros of technical analysis?

Although technical analysis is no guarantee for successful trading, it has advantages. 

  • Technical analysis uses data to make better informed trading decisions than following one’s gut feelings.
  • Traders that use AI investing bots can profit from their ability to do technical analysis at large scales and high speeds.
  • Trends and repeating patterns can reveal insights about how prices will move in the near future. 
  • Technical analysis tools can generate buying and selling signals and make the life of traders easier. 
  • The method can be used in different markets, such as stocks, forex, crypto, and other assets.
  • Technical analysis can be combined with other methods and add insights traders might otherwise miss.

There are many technical indicators, but it is up to traders to make the final trade decision. Photograph: TradingView

What are the disadvantages of technical analysis?

The main disadvantages of technical analysis are: 

  • Traders need to identify and interpret patterns and indicators. Their conclusions have a highly subjective aspect and that can lead to losses. 
  • Technical analysis only takes historical prices and volume data into account. It ignores fundamental aspects, like the company’s performance and economic conditions, which also impact prices.
  • There are many tools and indicators to do technical analysis. Beginners can feel especially overwhelmed.
  • The past is no guarantee of future success and technical analysis offers no guarantee for successful trading.

Is technical analysis enough for trading?

No, technical analysis is not enough for successful long-term trading . Traders can interpret technical data differently, and technical analysis tends to ignore important aspects that can influence the market.

Other elements that can contribute to becoming a successful trader are risk management, fundamental analysis, and trading plans that outline an overall trading strategy.

Yet, it is a valuable tool for professionals, day traders and retail traders. AI bots even take technical analysis a step further with their algorithmic trading.

Technical analysis is only one method to make informed trading decisions. Photograph: TradingView

How do I start learning technical analysis?

Learning technical analysis has become much easier since AI technology is doing the hard work. However, that doesn’t mean that relying on automated AI trading will eliminate all risks and only yield profit.

As a beginner, it is wise to study the basics of the financial market. Then, you can dive deeper into more advanced topics of technical analysis. 

The best next step is to practice without putting your money on the line. There are many online resources that show financial charts with technical data and indicators, like Google Finance, Yahoo Finance and TradingView. These are excellent training tools to identify patterns and see which indicators make the most sense for you.

Trading tools allow users to generate charts with their preferred trends or patterns. Photograph: TrendSpider

How accurate is technical analysis?

Like any other method to make trading decisions, technical analysis cannot guarantee 100% accuracy. That is partly because there are many technical indicators which can give misleading signals. 

Another important reason technical analysis is not always accurate is that it assumes all factors are included in the price. In reality, however, markets are highly impacted by events nobody can foresee, like Covid and wars, for example.

Finally, technical analysis is subjective and traders can interpret the same data to jump to different conclusions.

Do technical analysis patterns work?

There is no consensus about whether technical analysis patterns work. Some traders achieve success by using technical analysis patterns and others don’t.

There are many patterns and technical indicators. That makes it hard to choose what to take exactly into account. Traders can also misinterpret signals or apps cannot have sufficient or correct data and make wrong conclusions.

Experience and investment profiles are highly individual and they also affect results, regardless of the method that is being used.

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