ARTICLES
Investment Analysis, Part 1: Technical Analysis
By Vasco Laranjo, CFA
In this article, I will discuss the topic of Investment Analysis, that is, the method used for making the decision regarding an investment in the stock market. There are two main approaches when undertaking the analysis of a stock traded in the market: Technical and Fundamental Analysis. It is important to understand that these methods use different inputs with the same goal of evaluating an investment opportunity. The structure of the article is divided into 3 parts: an introduction defining the two mentioned approaches, a deeper examination of Technical Analysis foundations and an overview of the application of some Technical Analysis indicators’. Therefore, given the extent of the concepts under analysis, I decided to divide this topic into two articles, with the upcoming one focusing on Fundamental Analysis.
Introduction
What is Fundamental Analysis?
In Fundamental Analysis, an investor aims to evaluate the value of a security by attempting to measure its intrinsic value. In that sense, the focus is based on the company’s Financial Statements, Management Board, as well as, the economy prospects and industry trends.
The relevant inputs used in Fundamental Analysis are:
- Financial Statement information: revenues, expenses and income;
- Growth prospects for the company: based on financial history and discussions with Management Boards;
- Industry trends and competitive factors: based on the previous two points and economic data.
What is Technical Analysis?
Technical Analysis aims at the study of market action for the purpose of forecasting future price trends, primarily using charts. The first and most important assumption is that market action discounts everything, that is, anything that can possibly affect the price is reflected in the price of that market. In that sense, oppositely to Fundamental Analysis, the investment goal is not to valuate a security’s intrinsic value but to identify in which direction the stock price will move in the short or long future, depending on the timeframes used.
The relevant inputs used in Technical Analysis are:
- Price: Open, High, Low and Close;
- Volume;
- Open interest – only futures and options.
As a final note in this introduction, it is interesting to note that in Fundamental Analysis one uses the concepts of over-valued or under-valued, whereas in Technical Analysis over-bought and over-sold.
Intro to Technical Analysis (TA)
I stated already the first premise where TA is based on: i) market action discounts everything; however, there are two more important ideas to its foundations: ii) prices move in trends and iii) history repeats itself. The first premise has the purpose of indicating that if anything that can affect a stock’s price is already reflected in it, then, all that is required is the study of its evolution: the price action. The second concept arises from the idea that price action of a market creates trends and the purpose of TA is to identify these trends at an early stage. Finally, the third premise is based on the belief that some trading patterns which have worked well in the past will continue to perform in the future.
As pointed out already, Technical Analysis applied to stocks uses only the price and volume as input. Thereafter, what is important is the evolution of these variables, which will lead to the instruments of Technical Analysis, which are mainly: Trend Lines, Support and Resistance Levels, Chart Patterns, Moving Averages and Oscillators.
- Trendline: can be defined as in an uptrend (bullish action), downtrend (bearish) or sideways (trendless).
- Support: is the though or reaction low and indicates a level on the chart where buying interest is sufficiently strong to overcome selling pressure.
- Resistance: is the peak or rally high and indicates a level on the chart where selling pressure overcomes buying pressure and price advance is turned back.
- Chart Patterns: are formations obtained from the evolution of price action which create patterns that have identified in the past, which reveal bullish or bearish psychology in the market. These chart patterns can identify continuation or reversal in a trend.
- Moving Average (MA): considers a specific time-frame (number of points in time), calculates the average of prices in that time-frame for a given period and then when there’s a new close, the average is calculated with the value of the new price (new point in time and dropping the oldest point in the time-frame).
- Oscillators: are indicators calculated based on formulas developed by traders to identify over-bought or over-sold conditions, more often than not, when the trend is sideways.
When it comes to Chart Patterns, it is important to note that there are two distinct classes: Japanese Candlesticks formations and the “Western” candlestick formations. I will not develop much on this concept, but it is important that the reader notes that, in my opinion, the “Western” formations imply more subjectivity. Further to that, the Python package comprising a broad range of TA indicators, TA-LIB, includes a long list of Japanese Candlestick formulas but it hasn’t a single formation from the “Western” patterns.
At this point it is important that the reader realizes that there are different ways of analysing trendlines, multiple types of Moving Averages and an almost endless list of Oscillators. Accordingly, hereinafter my goal is to share the sources and resources I use when applying TA in my Investment Analysis.
Applying Technical Analysis (TA)
Disclosure: at the moment of writing this article, I have no connection whatsoever with the people or institutions responsible for the developing of the mentioned resources.
First of all, I obtain Historical Market Data via Yahoo Finance. It is possible to obtain this data in the website downloading a file in .csv format; however, I am currently using a Python package to obtain it in a faster/more convenient way. As far as TA Indicators are concerned, again I make use of a Python package to make these calculations: TA-LIB. Finally, for the definitions and explanations of the TA indicators, I tend to use Stock Charts. Please note that in the end of this article I include the Python’s Code Source where you will find the mentioned packages.
For the final part of this article, I decided to include a table including a series of Technical Indicators so that the reader can have a perception of the concepts under analysis. The table includes stocks from the S&P 500.