A brief introduction to technical analysis
The beginner’s guide
Technical analysis (TA) is the practice of evaluating past financial data and trends in an effort to predict future price movements.
The main assumption of technical analysis is that market trends — including price levels and movements, as well as trading volume and momentum — tend to repeat over time. Because of this, different market events can create trading signals that indicate different buying and selling opportunities.
In order to identify trading signals, technical analysts use candlestick charts, financial indicators and other technical tools to identify the various patterns and trends that may suggest future price changes.
While technical analysis is widely used by professional traders and investors, it is not without its limitations. Critics argue that it relies too heavily on historical data and may not take into account fundamental factors that can affect market movements. Some of these factors include variables such as marco-economic trends, geopolitical events, regulations, and industry trends. Hence, when developing a trading strategy using technical analysis, it is important to keep the famous financial phrase "past performance is no guarantee of future results" in mind.
Origins of technical analysis
While some elements of technical analysis can be traced back hundreds of years, Charles Dow is widely seen to have pioneered technical analysis in the early 20th century. As the founder of Dow Jones & Company, he created the Dow Jones Industrial Average in 1896 which was the first index of its kind to track the performance of the U.S. stock market. As markets matured and more sophisticated analysis methods were developed, the field of technical analysis emerged.
Years later, computers made the various tools and techniques used to analyze markets more accessible to a wider range of traders and investors.
From traditional markets like commodities and bonds to emerging industries like cryptocurrency, traders use technical analysis to identify trading opportunities and inform their trading decisions.
Understanding support and resistance levels
Support and resistance
Support and resistance levels are two important concepts in technical analysis:
- Support is a level that prices do not drop below. Support levels act as a price 'floor' or lowest price level consistently reached during a given trading period or market cycle. Despite prices hitting a support level multiple times, it acts as a place where buyers outnumber sellers.
- Resistance is a level that prices do not exceed. Resistance levels act as a price 'ceiling' or highest price level consistently reached during a given trading period or market cycle. Despite prices reaching a resistance level multiple times, it represents a place where sellers outnumber buyers.
In TA, the more times a particular asset’s price "tests" a support or resistance level, the stronger that level is considered to be. In other words, the more times a price reaches, but does not cross the line, the more likely it is that this line will hold as a short-term price minimum or maximum.
Support and resistance range trading
When viewing a candlestick chart, you may see the price of an asset 'bounce' between support and resistance levels. Many traders feel they can capitalize on price changes between support and resistance levels through strategies like range trading. Range trading techniques mostly center around buying the asset as the price nears lower levels of support and selling the asset as it approaches higher levels of resistance.
Once a particular level is breached, it may serve as the opposite level in the new trading range. For example, if the price of an asset increases, the price that was previously the upper resistance level may serve as the new lower support level of the new trading range.
While support and resistance levels are commonly used indicators, neither of these levels are guaranteed to hold. As with any information gleaned from technical analysis, it's wise to cross-reference findings with other data sources and manage risk accordingly.
Why use technical analysis?
As Mark Twain famously said “history doesn't repeat itself, but it often rhymes.” With this in mind, traders often employ technical analysis techniques to observe the past in an effort to predict the future.
Technical analysis is primarily used to:
- Identify current trends and market sentiment: Technical analysis can help traders identify trends and market sentiment in order to inform their trading decisions. By analyzing price charts and technical indicators, traders can gain insights into the direction of the market and can place trades accordingly.
- Provide objective data: Technical analysis relies on objective data, such as price and volume data, which can be more reliable than subjective opinions or emotions when making trading decisions. This helps traders avoid making emotional or impulsive decisions.
- Develop a systematic approach: Technical analysis provides a systematic way to analyze a market. By following a set of rules and criteria, traders can develop an investment strategy that is consistent and repeatable.
- Formulate short-term trading: Because it can help traders identify short-term trends and market movements, technical analysis is often used for short-term trading. This can be useful for traders who are looking to make quick profits on short-term price movements.
- Inform other types of analysis: Technical analysis can be combined with other types of analysis, such as fundamental analysis, while developing a more comprehensive view of the market. By combining different types of analysis, traders can make more informed and comprehensive trading decisions.
What are the different technical analysis tools?
There are many different tools used in technical analysis. Each of these technical indicators offers a unique perspective on past price movements while also having its own strengths and weaknesses in predicting future trends as well.
Some of the most commonly used technical analysis tools are:
Charts provide a visual representation of price and trading volume data over time. Charts allow technical analysts to identify trends, trading patterns, and support/resistance levels. Technical analysts use several different types of charts, including basic bar charts and line graphs that show price levels over time. However, most technical traders use the more sophisticated candlestick charts, which help to visualize a large amount of relevant trading information.
Candlestick charts allow traders to track price changes within a given time period. Within candlestick charts, technical analysts look for a variety of chart patterns that may indicate different future trends. Visualizing different prices and trading volume changes helps technical analysts track price movements and identify potential trend reversals. Candlestick patterns are often used to identify different bullish or bearish price movements based on the shape and position of individual candlesticks on a chart.
Simple moving averages (SMAs)
SMAs are used to smooth out short-term fluctuations in price data in order to help identify longer term trends. SMAs are calculated by adding up the closing prices of an asset over a specified period of time and then dividing the sum by the number of periods. SMAs can be calculated using different time frames, from short-term (such as 10 or 20 days) to more long-term (such as 50 or 200 days) periods. SMAs are commonly used to gauge support and resistance levels while finding potential buy and sell opportunities.
Oscillators are indicators that measure the potential change in trend and momentum of price movements. Oscillators use mathematical calculations to measure the momentum or strength of an asset's price movement over a given period of time.They can help identify overbought and oversold conditions, which can signal potential reversals in the market price as well as trading opportunities.
Relative strength index (RSI)
RSI is a popular oscillator that measures the strength of an asset’s price action by comparing the magnitude of its gains to its losses over a given period of time. Relative strength index is calculated using the formula
RSI = 100 - [100 / (1 + RS)]
where RS = Average Gain / Average Loss for a given period of time (such as 14 days). An RSI reading above 70 indicates overbought conditions, while a reading below 30 indicates oversold conditions. Values between 30 and 70 are considered in the neutral zone and indicate that the asset is neither overbought nor oversold.
Moving average convergence divergence (MACD)
MACD is another tool used to identify changes in momentum, trend direction, and potential buy or sell opportunities. The MACD indicator consists of a MACD line and a signal line. When the MACD trend line crosses above the signal line, it is considered a bullish signal and may indicate a potential buying opportunity. Conversely, when the MACD line crosses below the signal line, it is considered a bearish signal and may indicate a potential selling opportunity.
Bollinger Bands are used to measure an asset’s price volatility and identify potential price breakouts. Bollinger bands consist of three lines — a single simple moving average (SMA) line and two standard deviation lines plotted above and below the average. While the SMA trend line represents the average price of an asset over a specific period of time, the upper and lower bands represent levels at which the price is considered overbought or oversold.
Fibonacci retracements are used to identify potential support and resistance levels based on the Fibonacci sequence — a series of numbers in which each number is the sum of the two preceding numbers (0, 1, 1, 2, 3, 5, 8, 13, 21, etc.). Fibonacci retracement levels are calculated by taking the high and low points of an asset's price movement over a certain period of time, and then dividing the vertical distance between these points into a series of horizontal levels based on the Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8%, and 100%.