This article is best suited for people who are new to trading and investing. Here, you’ll find the basic concepts of technical analysis explained in simple English. This article aims to help you improve your trading strategy by using technical analysis in an efficient manner.
Technical analysis is simply the use of charts to study prices. Traders and analysts use it to predict future prices by analyzing historical prices. They do this by comparing past trends with current trends. It helps the traders sell high and buy low. The basis of technical analysis is the belief that the past repeats itself. In some cases, technical analysis can help you predict future prices accurately and concisely. In some cases, it doesn’t. Still, it is areasonableway for you can use to forecast future prices. It can certainly help you reduce risks associated with trading and maximize your profit. When trading, knowing what prices will be in the future is not essential. What’s important is your capability to improve your chances of making profits. Even if you’re using a simple technical analysis strategy, you will have gained leverage that you wouldn’t have without this analysis.
Why technical analysis?
Firstly, technical analysis provides an explanation of current and past prices. It contains past records of what happened in the market. The past records allow traders and analysts to study the past market. It will enable traders to have a closer look at the market. Traders can observe many things, such as past market volatility, extreme historical prices, and the average duration the price takes to reach a high from its low. A trader can get this information only by conducting a technical analysis. Before making any trading decision, you need to go through this information. Conducting a technical analysis can help a trader identify and understand past price action. Then, traders need to assume that past price actions are repetitive to some certain degree. With that assumption, they predict future prices.
The basis of the process of forecasting used in technical analysis is market action. Traders and analysts can best study the market action via volume, sediment, and price. Analysts use past information captured in charts to predict future price action.
Here are two basic approaches to technical analysis that traders and analysts use.
- Mean-reverting.
Traders that use this approach expect prices to continually return to their average value. These types of traders are always searching for trend reversals. They use technical analysis tools to find oversold or overbought stocks. These include tools such as moving averages and Bollinger bands. They enter a trade during flat consolidation areas.
2. Non-mean reverting.
These traders expect prices to maintain a strong trend. They are always looking for continuation patterns and indicators. They use technical analysis tools to find trend continuation activities. These include tools such as the Darvas Box and the Donchian channel. They usually enter the trade during an uptrend or a downtrend.
Subjectivity in technical analysis.
The work of a technical analyst is to identify indicators, analyze data, and predict future price action. However, the part of analyzing data using technical analysis is subjective. What largely contributes to this subjectivity is that traders and analysts can analyze charts in numerous ways. Each analyst must choose which indicators to use when analyzing a chart. They must also decide which technical analysis approach best suits a particular chart. And this may vary between analysts. There are various ways that analysts can use to view the market. They all depend on the “why”. If an analyst wants to know more about price exhaustion levels, they will use appropriate tools. These may include tools such as Bollinger bands, areas of support and resistance, and Keltner and Starc bands. If they want to know more about the momentum of price action, they will use tools for finding momentum. These may include tools such as moving averages, trendlines, and major chart patterns.
Subjectivity: Contradiction
Two indicators may contradict each other. For example, one may indicate that the chart is approaching a trend reversal. In contrast, the other indicator may indicate a trend continuation. This contradiction results because each indicator is built differently and uses different time frames. Sometimes, missing data on the charting platform causes this contradiction. If, for example, an indicator uses open interest in its calculations. However, the charting platform that the analyst uses does not have an open interest. Then, this indicator will provide inconsistent results. These conflicting results can confuse many analysts as they may not be aware of this missing data. Other times, this contradiction happens because different charting platforms use different data types. For example, a charting platform may use tick volume instead of volume. Tick volume does not consider the size of a transaction, whereas volume does. This example alone causes a lot of inconsistency in chart indicators.
This mentioned above explains what may cause subjectivity in technical analysis. Since analysts use different charting platforms, their analysis is prone to be different from each other.
Advantages of technical analysis.
- Provides charts that make it easy to visualize the market. For example, studying volume and volatility on a chart is more straightforward than in numbers.
- Provides the exact best time to enter or exit a trade. The technical analysis tools and indicators help traders locate a potential time of entry. They also indicate whether the market is bullish or bearish.
- Eliminates the need to study the fundamentals of a stock. Information on the charts already reflects all that a trader needs to know about a stock. The price reflects all the factors that may affect the stock.
- Technical analysis can be used in all types of markets. A trader can use the same technical analysis skills and tools whenever they want to trade a new market. Unlike fundamental analysis, a trader needs to know all the ins and outs of a stock they want to trade.
Disadvantages of technical analysis.
- There is ambiguity in the interpretation of charts. Different analysts and traders may interpret charts differently. This uniqueness makes the interpretation of charts subjective.
- The accuracy of technical analysis can be disturbed by rare events that cause unexpected volatility in the market. This is because technical analysts predict future prices based on the hope that the past will repeat itself. Therefore, any usual events that the charts have not recorded in the past cause errors in chart analysis.
- Mastering the art and skill required to predict future prices from historical past action is challenging. Traders can use technical analysis tools and indicators in any chart interpretation. It is still important to note that each market is different in its own way.
- Price action in the market can act at random. This results from the uncoordinated action of the high volume of market participants. Market participants include retailers, investors, institutions, suppliers, speculators, consumers, and professionals.
Vocabulary that is primarily used in technical analysis.
Charts are the building blocks of technical analysis. They make it easy to evaluate and study historical prices. The most popular charts you need to know are line charts, bar charts, and candlestick charts. Charts provide historical price movements. They help in viewing how a specific currency pair has reacted to certain factors in the past. Therefore, it allows traders to make informed decisions regarding any trade. Charts also determine how strong the demand or supply is and help predict future price actions.
Line Charts
The line drawn from the opening price to the closing price of that specific time frame. Let’s have a look at the figure below. This line chart represents daily price movements in the market. In this case, each line connects the opening price of a specific day to the closing price of that particular day.
These kinds of charts show minimum information. They are a great way of clearly indicating trends. But they provide shallow details on price movements. Therefore, traders use line charts to get the best view of trends and the summary of the price behavior.
Bar Charts
These are the most popular charts in Forex. The arrangement of bars is according to changes in time. Individual bars that come together to make a chart make up a bar chart. A single bar represents the currency pair traded at a specific time range. The time periods can be 1-minute, 5-minute, 15-minute, 30-minute, 1-hour, 12-hour, daily, weekly, monthly, or yearly. As indicated in the figure below, each bar shows the open and close prices and the high and low prices traded. The height of the bar indicates the difference between the lowest price and highest price at one time segment.
What sets the bar charts apart from the line chart is that it shows the price volatility in the market.
Candlestick charts
The prettier version of a bar chart. These charts are easier to read compared to any other charts. Candlesticks reflect bullish segments using a green color and reflect the bearish segments by using a red color. In the bullish segment, the closing price is higher than the opening price. Experts highly recommend candlesticks charts to people who are new to Forex. The color system of candlesticks makes them easy to use in technical analysis. Also, candlesticks make it easy to identify market changes like trend reversals. Candlesticks also have patterns analysts and traders can use to interpret price movements. Analysts categorize these patterns into four categories, namely the bullish patterns, bearish patterns, reversal patterns, and neutral patterns.
Introduction to Chart Patterns.
You may ask yourself why you must study past chart patterns since they are subject to change. To answer that, studies have proven that these patterns cannot be random. Human behavior influences chart patterns. And many factors drive human behavior. Therefore, if you have information on these factors, you can confidently predict how humans may react to them. Hence, it is possible to predict price actions based on chart patterns.
There are many factors that can influence price movements, such as sociological factors, psychological factors, and market sentiments. The problem with these factors is that they cannot be calculated or quantified. Here is where chart patterns come in handy as they reflect how people feel about these factors. Reading charts requires intuition and belief. Experience builds this belief and intuition. Therefore, starting out, you should start trading with a demo account. A demo account will help you get a feel of how chart patterns work, allow you to hone your chart reading skills, and gain experience. After using a demo account, you will be confident in identifying chart patterns.
Why use chart patterns?
Observing chart patterns allows you to be like the indigenous ticker tape watchers. Just like them, you can learn to sense when a trade is under accumulation. You’ll be able to observe many things. As to when the price increases due to the rise in volume. Or when the prices decline due to the decrease in volume. Like ancient tape readers, you’ll know when to buy or sell. Many people nowadays opt to use computers and their programming skills to determine chart patterns. As a result, they shy away from observing these patterns themselves. Therefore, you can have a natural advantage compared to those who trade using formulas programmed in a computer. If you’re new to trading, it is better to gain practical experience than to rely on trading software.
Challenges associated with chart patterns.
Here are some common problems observed in all traders new to technical analysis. They often see chart patterns where there is none. They often mark a “pattern” that is too small to be an actual pattern. Sometimes, they mark an upside-down or inverted pattern as an existing pattern. And even if they have noticed a correct chart pattern, they misuse it. Studies also show that intelligent people also struggle with reading chart patterns. They prove that chart reading is a skill traders and analysts can develop over time. And the only way you can develop this skill is through practice.
