If you have taken a look at trading techniques, chances are that you have come across technical analysis. This trading technique involves evaluating movements in prices and identifying trends. Traders look at technical indicators and price charts of an asset for determining the trend or direction in which it will go. Technical analysis doesn’t include any fundamental analysis, such as evaluation of a company’s balance sheet. Instead, this form of analysis involves focusing on price movement, patterns, volume and other indicators. The use of technical analysis is applicable across all trading markets, whether you are trading commodities, equities, stocks, futures, forex, cryptocurrencies blog and more.
Important Concepts of Technical Analysis
There are certain principles that are involved in technical analysis and you need to be aware of them in order to make use of it. Let’s check them out:
- The first major principle of technical analysis involves analyzing the past for predicting the future. Technical analysis believe in the idea that history is likely to repeat itself because price movements are cyclical. While past performance cannot guarantee future results, there are some common patterns that do tend to repeat over time.
- Another important principle of technical analysis is that the market price of a security or asset reflects all information available. When the market is efficient, there is no need to perform fundamental analysis because everything has already been factored in.
- One more principle of technical analysis is that prices shouldn’t be considered random. Technical analysts believe that prices are following trends. Trends can be long-term, medium and short-term. The basic concept of technical analysis involves identifying the trend for predicting future movements in price.
Basics of Technical Analysis
There are no fundamentals involved in technical analysis and you don’t have to focus on the intrinsic value of an asset. The primary focus is on price action, trends, chart patterns, volume, momentum and more. So, how can these be used for analyzing an asset? Read on to find out:
Identifying a trend is one of the most vital elements of predicting the forthcoming performance of an asset. Examining short-term, medium or long-term trends assists a trader in forecasting whether a price will go up and down. Past movements in prices and patterns can indicate how an asset is likely to perform in the future. If the trader is able to identify the trend, they will be able to make profitable trades. The overall direction of an asset is indicated by the trend.
There are three kinds of trends that exist; sideways trends, uptrends and downtrends. The first move horizontally and are considered a signal of consolidation. The second have higher highs and higher lows while the third have lower lows and lower highs. It is possible for the short-term trend to be downtrend and the long-term to be uptrend.
Swing traders are more likely to make use of medium and long-term trends whereas scalpers and day traders prefer to use very short-term trends.
Technical analysis is made possible by the past and current price of an asset. The price is recorded in the form of charts, which track the historical performance of the asset. Before the existence of computers, these charts were drawn by hand. The price of an asset itself can tell a trader about demand and market sentiment. When there are more sellers, the price goes down and it goes up when there are more buyers. Past performance can be illustrated through a chart, which can make the direction more clear. Price charts can be used by traders for identifying patterns, trends and volume.
One of the most important factors in technical analysis is analyzing trading volume. Volume refers to the number of contracts or shares that are trading. It is possible to analyze volume at different time periods, but the most common is daily volume. It is used by traders for finding out the strength of a price movement. When there is a downtrend, the volume is low during up moves and high during down moves. The opposite is applicable for an uptrend. Volume can also be helpful for confirming a chart pattern. If a stock breaks out over a big trend line on low volume, it is regarded as a false breakout. High volume is used by traders for confirming significant movements or trend changes.
Another one of the major ways of performing technical analysis is through chart patterns. When past prices are put into charts, it is easier for traders to identify patterns. Some of the most common charting patterns include:
- Ascending triangle
- Descending triangle
- Head and shoulders
- Double top or double bottom
- Inverse head and shoulders
- Triple top or triple bottom
- Cup and handle
- Falling or rising wedge
- Bullish or bearish symmetric triangle
Charts are used for drawing and identifying trend lines and areas of resistance and support. The visual representation provided by a chart allows traders to see how assets react to fundamental changes and market news. There are variety of charts that can be used for technical analysis. The 3 most widely used chart types are bar chart, candlestick chart and line chart. The candlestick chart is the top preference of traders because it can account for several time frames into single price bars.
The movements in the stock price can be simplified with the help of moving averages. Rather than focusing on daily changes in price, they are more focused on the average changes. There are two types of moving averages; simple moving averages (SMA) and exponential moving averages (EMA). For calculating a simple moving average, the total amount of all closing prices for a particular time period is taken and then divided by the number of days. A much more complicated formula is used for EMA, which puts more emphasis on recent prices.
Relative Strength Index (RSI)
This is a momentum indicator and its purpose is to measure the significance of recent changes in price for determining oversold or overbought conditions. It tracks the number of price decreases and increases over time. The 14-day period is the most common time frame. A value will be assigned by the RSI between 0 and 100. A value of 70 or higher is regarded as overbought while a value of 30 or lower is regarded as oversold.
Support and Resistance
The support and resistance levels of an asset is examined by technical analysts for determining whether it is in a bearish or bullish path. The previous highs are regarded as levels of resistance while the previous lows are considered as support. The support level refers to the price that has enough demand to prevent it from falling further. The resistance level is one where there is not enough demand for driving the price higher and sellers can take in profits.
It is considered a bullish signal if the price breaks above a resistance line and the price is expected to increase. In contrast, it is a bearish signal if the price breaks below a support level and it is expected to fall lower. Once the stock or security has fallen past a line of support, the previous one now becomes a resistance. If it goes past a resistance level, then the previous one is considered support. The price of assets tend to bounce between resistance and support lines. Therefore, if you want to identify trends, along with any possible reversals, it is important to be aware of areas of resistance and support.
Other Oscillators and Indicators
Price statistics are used by indicators for calculating chart trends and patterns. They are created for determining buy and sell signals for helping traders know when to exit or enter a trade. Traders can use technical indicators for confirming price movements and developing a profitable trading strategy. Some of these indicators are referred to as oscillators. They are tools, such as the RSI, which allow traders to analyze overbought/oversold conditions and momentum. Some of the popular indicators that are used in technical analysis include:
- Money Flow
- Bollinger Bands
- Fibonacci Retracements
- Moving average Convergence Divergence (MACD)
- Ichimoku Cloud
- Stochastic (similar to RSI)
How to Perform Technical Analysis
The first thing you have to do is choose a stock, security or any other asset and then pull up its price chart. After you have done so, it is a good idea to try and draw a trend line. You can form the trend line by connecting three or more lows and highs. Observe the price movements of the security or stock in order to confirm if they are following the trend line you identified. You can also add some moving averages for identifying the short-term trend and the overall long-term trend. If the trend trade tools starts to change, you should check the volume for confirming the strength behind the movement. You should get acquainted with the charting tools available and keep things simple in the beginning. Like everything else in life, you will get better at technical analysis with practice.