The Ultimate Guide to Technical Analysis
Technical analysis uses price trends to determine future price direction. Technical analysts study existing price movements, and how prices may potentially move.
10th March 2022 - 11:50 am
Technical analysis is one of the most widely used analytical tools in the world of trading. It uses past price movements and trading volume to predict how prices may move in the future.
As a trader, technical analysis is one of two go-to analysis tools for your trading activity (the other being fundamental analysis). Read on to find out just how technical analysis works, and how it can help you in your trading journey.
This article at a glance:
- Technical analysis uses price trends to determine the direction of future prices using historic price and volume data.
- Technical analysis can give you specific indications of when to enter or exit a trade. The price paints a clearer picture of what can happen in the future, and takes the guesswork out of trading.
- Charts are integral to technical analysis. They contain all the information required to make a decision.
- Technical analysts rely on a number of indicators and data points when making estimations of future price movements.
- Technical analysis deals with the probabilities of a price event, not absolutes.
What is technical analysis?
Technical analysis is a type of analysis that uses price trends to determine the direction of future prices using historic price and volume data. Traders use technical analysis as a structure to study existing price movement, using that as a metric to predict how prices may potentially move.
The methodology of technical analysis is market-agnostic. This means that the approach remains constant, no matter which market you apply it to, which is why it’s an excellent framework to have in your trading kitty. You can apply the framework to most assets, from currencies, commodities, and bonds, to interest rates and equities.
As an approach, technical analysis is based on three widely-recognized premises:
- The market discounts everything – all the information you need regarding a financial asset is reflected in its price.
- Prices move in trends – market prices move in trends, so they demonstrate some degree of consistent behavior over a period of time.
- History repeats itself – trends happen in cyclical patterns. This is because the market is a reflection of the collective trader sentiment. The human psychology backing their decisions is predictable to a certain extent, and subsequently, so are the outcomes.
Why use technical analysis?
Traders use technical analysis for many reasons, not least because it’s a mixture of science and art that dates back to centuries.
- Studying the history of technical analysis lets you grasp how it has evolved and is used today. This will enable you to apply it through a 21st-century trading lens.
- Knowing when to buy or sell beforehand is a trading advantage. Technical analysis can give you specific indications of when to enter or exit a trade.
- The price paints a clearer picture of what can happen in the future, and takes the guesswork out of trading.
- When there’s money on the line, you don’t want to go in blind. Technical analysis is a good way to guide your trading decisions based on market evidence.
Where does technical analysis come from?
Analysts have developed several technical trading indicators over the years to master technical trading. And by over the years, we mean many, many years — technical analysis in its earliest form dates back as far as the Babylonian civilization.
The version closer to its present-day avatar flourished in the 19th century, after journalist Charles Dow introduced his formalized version of the theory in the late 1800s. Needing to correlate patterns for his newly-created Dow Jones Industrial Index, Dow opened the door to technical analysis by studying the movements of the market.
However, Dow only took the framework so far. Technical traders such as William P. Hamilton, Robert Rhea, Edson Gould, and John Magee added to the Dow Theory. William P. Hamilton was essential to the growth of the theory, incorporating extra indices that improved the structure’s accuracy.
Today, technical analysts and traders continue to take the Dow Theory further by leveraging a multitude of patterns that are curated after decades of intensive research.
We talked about how technical analysis is based on the theory that all that is known or can be known about a financial asset is in its price. This technique isn’t interested in the underlying value of an asset, but the probability of a price-related event taking place.
Where can the data be found? On the charts. Charts are integral to technical analysis. They contain all the information required to make a decision. This is why analysts are also known as “chartists”.
These four basic charts are foundational to technical analysis:
Candlestick charts use the lows and highs from a set period – an hour, a day, a week, or a month – to reflect price movements. These candlestick-shaped price markers tell analysts and traders how much the price opened at, moved, and closed, within a unit of time.
What you need to know about candlestick charts:
- The horizontal lines (the top and base of the candle) denote opening and closing prices.
- Clear candlesticks show trades with higher closes than openings, whereas the opposite is true for blocked-out candles.
- The top and bottom “wicks”, or vertical lines at each end, tell us the highest and lowest price points that the asset traded at before finally closing.
Bar charts present the same data as candlestick charts do, but a different format. It’s also possible to customize these charts in case you don’t want to see the opening price.
What you need to know about bar charts:
- Bar charts plot price movements differently from candlesticks, even though the data they give out is the same.
- They appear as a single vertical line showing highs and lows.
- Two horizontal lines at the top and the bottom denote opening and closing prices. They extend from the main line to the left and the right.
- The left lines signify openings, and the right lines show the closes.
Point and figure charts
A point and figure chart plots columns of Xs and Os to reflect rising (Xs) and falling (Os) prices. Unlike bar and candlestick charts (which show the range of price movements), new entries on a point and figure chart are only added when a fixed movement in price occurs. Any price movements that don’t meet the set target are omitted from the chart.
What you need to know about point and figure charts:
- New Xs (marked by green boxes below) or Os (marked by red boxes below) are added to the chart depending on the box size.
- For instance, if you set the box size at 5 USD, a point on the chart will only be marked if prices move by that much.
- Box sizes can also be set as a percentage of current price.
- A second target is reversal price, again, set by the trader.
- A point and figure chart will continue to plot in the upwards or downwards movement, regardless of price changes that are less than the reversal price. Once prices hit the set reversal prices, the graph will start to plot the new direction — Xs will switch to Os, and the other way around.
Perhaps the easiest chart of the four to understand, line charts plot single price points (typically closing prices) on a graph. A line connecting these points across the chart forms the line graph. The concept is akin to what you may have studied in high school. These charts are useful for a simplistic rendering of closing prices over time, but you’re more likely to use other chart types when actually trading.
These chart types are widely used in newspapers and reports for the general public, because they’re easy to read and understand.
Technical indicators: What data does technical analysis use?
Technical analysts rely on a number of indicators and data points when making estimations of future price movements. These are crucial to your trading activity. Find out more about the most common ones below.
If you’re a beginner, don’t get daunted by the jargon. Focus on what the indicator is telling you instead. Experience is the best teacher, so remember to test these indicators out on a trading platform such as MetaTrader.
Trend lines are a manual indicator. Trends don’t move in straight lines, making them hard to spot and plot on a chart. To make trends easier to follow, analysts look at the highs and lows of assets over a predetermined period. The average direction of the trend – up or down – indicates possible future price movements.
- Uptrends consist of higher highs and higher lows
- Downtrends consist of lower highs and lower lows
- Sideways trends consist of inconsistent movements in either direction
Support and resistance levels
Support and resistance are high and low price levels at which prices sustain themselves. When prices fluctuate but do not cross a certain price level over time, they form support or resistance levels.
- Support levels – when prices fluctuate, but do not fall beyond a certain price level over time, they form a support level.
- Resistance levels – when prices fluctuate, but do not rise beyond a certain price level over time, they form a resistance level.
When prices breach support or resistance, they are referred to as breakout points. These breakouts may indicate the formation of a new trend.
Correlation indicators relate to the relationship between two assets. For example, petrol prices increase when the cost of oil increases, making it a positive correlation. When the opposite happens, such as rising oil prices and airline stocks, it’s a negative correlation.
Fun fact: Negative correlation is extensively used by investors to diversify portfolios and reduce risk.
Price fluctuations make charts harder to read because they hide otherwise obvious patterns. Moving averages help to fix the problem by plotting previous price movements from defined periods of time. These periods of time depend on the trader, you can have as little as five periods of one minute, or 200 periods of one day. Sometimes, they can be applied to periods even beyond 200 days, as the Dow Theory says that primary trends can last for one year.
The Standard and Poor's 500 (S&P 500) is a fantastic learning curve because its 50-day moving average has shown time and again as a point at which the market reacts. If the price is above the 50-day average line, it’s a sign that it will continue to trend upwards. As price always returns to the median, this would be when traders buy, on the understanding that it will recover again immediately, and continue in the same direction.
Moving average types include:
- Simple moving average (SMA) is a straightforward average of prices (typically closing prices) over a period of time. Traders often compare the SMAs of different time periods (50 days, 100 days, 200 days etc.) to work out patterns in price movements.
- Weighted moving average (WMA) works similar to the one above, but adds more weight to prices that are recent. It linearly adds lesser weight from recent to past prices. This makes the WMA more sensitive to the possibility of a trend than an SMA.
- Exponential moving average (EMA) is also a weighted average, but the weightage assigned to prices drops exponentially. This means that the EMA assigns much more weight to recent prices than a linear WMA would.
Relative Strength Index
The Relative Strength Index (RSI) is a momentum indicator that oscillates between a set minimum (0) and maximum (100). It is used to understand how fast prices are changing, and by how much.
- When the RSI drops below 30, it tells traders that the asset is oversold, and an upwards reversal may be imminent.
- Similarly, when the RSI goes beyond 70, it indicates that the asset is overbought, and prices are likely to reverse downwards.
Moving Average Convergence Divergence
The moving average convergence divergence (MACD) indicator is also an oscillator, like the RSI. They are denoted by two oscillating lines.
- One line stands for the 12-period EMA, while the other shows the 26-period EMA (in case you missed it, read our explanation of EMAs above).
- A third line, the 9-period EMA, denotes the “signal line”.
- The points at which the lines converge or diverge tell the trader about a possible bullish or bearish trend, and indicate possible points to buy or sell.
Avoid these technical analysis mistakes
Technical analysis is not foolproof. Here are some red flags to keep in mind when using this type of analysis:
Technical analysis doesn’t factor in everything
A tenet of technical analysis is that all the information you need is reflected in the price. But viewing it as the Holy Grail of market data is not always accurate, because it deals heavily with probabilities, and not absolutes.
History doesn’t repeat itself exactly
As lightning doesn’t strike twice in the same place, neither do price movements behave exactly the same way. Models are hard to interpret as a result, and trends may look similar but never the same.
Using too few, or too many indicators.
One indicator is too few, and seven is too many. Traders generally stick with a maximum of three indicators when trading. Remember, you don’t want to confuse yourself but you also want to gather enough information.
Rely on the same indicators for every kind of market movement
Some indicators are more suited for a trend, whereas some others for a range. Familiarize yourself with the different indicators on your trading platform — the more you practice, the more you’ll be able to judge which ones to use.
Technical analysis FAQs
How accurate is technical analysis?
Investments are unpredictable, so there are no promises when you pick securities to trade. Technical analysis may evaluate how an asset will perform in the future, but it only deals in probabilities of a price event.
How many securities should you buy?
Portfolio diversification is essential if you want your investment to stand the test of time. However it depends on your trading and investment style as to whether you should buy lots of securities. If you’re looking to buy and hold for a significant period of time, then up to 20 might be seen as standard. But if you’re an active day trader, holding 20 open positions might be difficult to manage, from a risk and performance standpoint.
Which chart should you use?
It depends on which chart you find the most comfortable. Indicators mustn’t be confusing, as that makes them counterproductive. Opt for readability over anything else. Most beginners prefer to start with candlestick charts because they’re easy to understand, but again, it all comes down to choice.
This material is for general information purposes only and is not intended as (and should not be considered to be) financial, investment or other advice on which reliance should be placed. INFINOX is not authorized to provide investment advice. No opinion given in the material constitutes a recommendation by INFINOX or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.