Technical analysis is the study of market data such as historical and current price data and volume in an effort to forecast future market activity. Historical price data is the most commonly used available data that is implemented into the analysis.
Historical market data is saved and forms charts over various periods of time. The technical trader can analyze varying periodical charts over a specific length of time for the basic purpose of picking the entry and exit levels of a trade. By studying the chart the chartist is able to get information at a glance that will hopefully represent the direction of the instrument in the future.
There is a never-ending argument between fundamentalists and technical analysts about which method of analysis will show the best results. Technical analysts will claim that all the fundamentals are already built into the price and so, apart from natural disasters and unexpected world events, the current price shows the market’s expected value taking all the known information into consideration. The chartists are in fact looking for patterns or repetitions in price movements to guess the likely outcome of future prices. In a word, they are looking for trends.
The field of technical analysis is based on three assumptions:
The Market Discounts Everything
Price Moves in Trends
History Tends To Repeat Itself
Another important idea in technical analysis is that history tends to repeat itself, mainly in terms of price movement. The repetitive nature of price movements is attributed to market psychology; in other words, market participants tend to provide a consistent reaction to similar market stimuli over time. Technical analysis uses chart patterns to analyze market movements and understand trends. Although many of these charts have been used for more than 100 years, they are still believed to be relevant because they illustrate patterns in price movements that often repeat themselves.
Technical analysis is a skill that improves with experience and study. The more you learn and practice the better you’ll be.
Using Technical Analysis
One of the first things heard in technical analysis is „the trend is your friend.” Finding the prevailing trend helps traders to become aware of the general market direction. Daily, weekly, and monthly charts are most ideally suited to identifying the longer-term trend. Once the overall trend is identified, technical traders will usually begin identifying the trend of their chosen trading timeframes.
Support and Resistance
Support and resistance levels are points where a chart experiences recurring upward or downward pressure. Support levels exist at lows while resistance levels exist at highs. Once these levels are broken, they tend to become the opposite. For example, if a support level is broken to the downside, that level often becomes a new resistance level. In a rising market, a resistance level that is broken could serve as support for the upward trend, while a broken support level in a falling market could serve as a new resistance level for the downward trend.
Trend Lines and Channels
Trend lines are simple, yet helpful tools in confirming the direction of market trends. An upward straight line is drawn by connecting at least two successive lows, but preferably more. Each successive point must necessarily be higher then the previous one. The continuation of the line helps determine the path along which the market will move. An upward trend is a concrete method to identify support lines/levels. Conversely, downward lines are also charted by connecting two points or more. The validity of a trend line is partially related to the number of connection points.
Moving averages can be very helpful in identifying the overall trend. Moving averages reveal the average price of a currency at a given point of time over a defined period of time. They are called „moving” because they reflect the latest average while adhering to the same time measure.
A weakness of moving averages is that they lag the market, so they do not necessarily signal a change in trends at the most advantageous time. To help address this issue, it’s advantageous to use a shorter period, which would be more reflective of recent price action than a longer period. At the same time, however, shorter period moving averages are subject to more false trend-change signals. Alternatively, moving averages may be used by combining two averages of different periods. Buy signals are usually detected when the shorter-term average crosses above the longer-term average. Conversely, sell signals are suggested when the shorter average falls below the longer one.
There are three main types of mathematically distinct moving averages – the simple moving average (SMA), the exponential moving average (EMA), and the weighted moving average (WMA). EMAs and WMAs assign greater weight to the most recent price data, while SMAs assign equal weight to all of the data in the period. For this reason, many traders prefer to use EMAs and WMAs to help combat the lagging nature of moving average signals.
Indicators and Oscillators
Indicators and oscillators vary immensely in their usage and derivation. The indicators that reside right on the price bars or candles include moving averages, Bollinger Bands, Parabolic SAR, and a host of others. These are usually lagging indicators providing a historical view of price action. They can often provide clues and confirmation as to the direction of past trends and present momentum.
The oscillators that usually appear as a separate entity above or below the price bars are also lagging. In contrast to the price indicators, though, oscillators excel at identifying overbought and oversold conditions. As such, they are of most use to traders who wish to identify ranging, rather than trending, circumstances. These oscillators include Stochastics, MACD, RSI, and many others.
Like analysis tools, technical drawing tools, aside from the aforementioned trend lines and channels, are both popular and varied. With several different incarnations of Fibonacci formations, as well as the Gann Fan, Andrew’s Pitchfork, and many others, chart drawing tools have a huge number of adherents. Most of these drawing analyses are meant to identify areas of importance, including support and resistance levels. Trend lines, whether diagonal or horizontal, are the most basic drawing tools. From there, they become increasingly complex, and often originate from complicated mathematical foundations.