i. Technical analysis is a trading method of studying price only and predicting how it will move in the future.
ii. Principles of technical analysis - history repeats itself, price moves in trends, and market discounts everything.
iii. Types of technical analysis - chart patterns and technical indicators.
iv. It works because of mass psychology of traders.
What is technical analysis?
Technical analysis is a trading method through which traders seek to forecast the direction of prices. In this type of analysis, historical market data is analyzed in order to predict future prices by solely looking at the price charts of currencies.
Technical analysis is one of the most widely used types of analysis that traders utilize in order to take short-term, medium-term as well as long-term trading decisions.
The effectiveness of technical analysis has never been questioned as certain tools of technical analysis have been used in other forms of trading analysis.
Technical analysis is based on two inputs - price and volume. There are certain rules or calculations that are applied to these two inputs of a currency which forms an indicator.
These allow traders to make effective trading decisions and helps traders in pre-determining entry, exit, and stop loss price levels.
The traders can look for trades that have a high probability of going in their favor as well as controlling their risk on the trades.
Principles of technical analysis
1. History repeats itself
The most basic principle of technical analysis is that history repeats itself. Technical Analysts believe that the markets are irrational and it leaves certain patterns.
These patterns can be used to study future price movements and capitalize on them.
2. Price moves in trends
There is a theory in technical analysis which states that price moves in phases. These phases are called trends.
Price could be moving upwards, hence in an uptrend, or could be moving down, hence in a downtrend, price moving within a fixed range is said to be in a sideways trend.
3. Price and market discounts everything
Technical analysts state that the price of an asset takes everything into account, hence it is futile to study the external effects on price.
They hold that events like earnings or reports may just cause a short-term fluctuation in price, but this is all factored in by price and in the long term price always moves in the prevailing trend.
Technical analysis - Types
Technical analysis is a subpart of the larger domain of trading analysis that could be further categorized into two types.
I. Chart patterns
1. Chart pattern basics
Chart patterns are the foundation of technical analysis. In this type of technical analysis traders look to identify certain levels on the chart which could have an impact on the price of the currency.
These levels are commonly known as support and resistance. Traders would determine these levels by the manner in which prices have reacted in the past at points.
Prices often leave patterns in the manner in which they reacted at certain points on the chart. Traders would spot these patterns, look for the underlying conditions and try to apply these to the price movements in the coming trading sessions.
2. Why chart patterns?
This method of trading is also known as price action trading, as all that matters here is the manner in which the price has reacted in the past around certain levels.
These patterns leave a footprint of the supply and demand prevailing in the currencies. This characteristic makes chart patterns a powerful tool in trading.
3. Chart patterns - The challenge
Since chart patterns are derived solely from the price charts of currencies, it becomes a very subjective form of analysis.
Traders look to spot patterns on the charts, but it is not necessary that every trader would spot the same patterns. There aren’t any specific rules that are applied when chart patterns are to be identified on the charts.
It is said that to spot a pattern, one needs the eye for it. This applies to chart patterns too, in order to effectively spot chart patterns, traders need to have on-hand experience, and they need to train their minds to recognize patterns.
Hence, the more charts that a trader studies and analyses, the easier it becomes for him to spot chart patterns and trade them.
4. Types of chart patterns
Chart patterns are of two types - continuation chart patterns and reversal chart patterns. This is based on the type of information that traders derive from these patterns.
i. Continuation chart patterns
These indicate a short-term consolidation or sideways movement of the price before it continues to move in the direction of the prevailing trend. Some examples of these types of patterns are triangles, pennants, flags, rectangles.
In order to trade the continuation chart patterns, traders are required to identify an already prevailing trend. The price must then form a pattern that would indicate that the price is consolidating.
The last step is to identify breakouts. The traders would take entries in the direction of the prevailing trend once a breakout has happened.
ii. Reversal chart patterns
These indicate a change in the prevailing trend of the price. These patterns may form at the top of an uptrend, indicating that trend has turned bearish or may form at the bottom of a downtrend, indicating that trend has turned bullish.
These patterns allow traders to take early entries in the new trend which if plays out right, fetches the trader good profits.
Some examples of reversal chart patterns include head and shoulders, double tops or double bottoms, triple tops or triple bottoms, rounded tops, or rounded bottoms.
II. Technical indicators
1. Technical indicators basics
Technical indicators seek to identify patterns in the price or volumes of a currency by applying various mathematical formulas to the same.
These formulas are applied to historical price or volume data of the currency in order to find trading opportunities in the coming trading sessions.
The primary function of technical indicators is to determine the momentum of the price change. Mere observation of chart may not give a trader the indication of momentum, but application and the use of technical indicators can all answer the questions on momentum.
2. Why technical indicators?
Technical indicators have straightforward rules. If the indicator turns bullish or gives a buy signal, the trader enters into long trades, whereas if the indicator turns bearish, or gives a sell signal, the trader enters into short trades.
These rules make the technical indicators more objective in nature. Every interpretation of the indicator made by traders will be the same hence the objective nature.
Technical Indicators can be used in both trending and ranging markets but it is necessary to use the right tools for each market condition.
These indicators can also work in tandem with other tools which gives a trader double confirmation and additional confidence in taking the trade decision.
3. Types of technical indicators
Overlays are those types of technical indicators that are directly applied to the price chart. They use the same scale as the price.
Some examples of overlays are moving averages, Bollinger bands, Keltner channels.
Oscillators are technical Indicators whose values oscillate between two extreme points, one being the maximum and the other being the minimum.
Why does technical analysis work?
Psychology here plays a big role. When lots of traders use the same tools then there is a really high chance of them identifying the same patterns, support and resistance levels.
This leads to lots of traders taking trades based on that analysis hence making the thing work. It is a saying that technical analysis is a self-fulfilling prophecy, it means that technical analysis makes certain predictions and it itself fulfills them.
The markets are greatly influenced by the psychology and behavior of the participants. This mass psychology is what makes technical analysis a reality.
Why should you use technical analysis?
The number one advantage of technical analysis is that everyone uses it. As discussed above the mass psychology around this type of analysis is what makes it effective.
While other traders use technical analysis to profit, new traders can do the same by using and applying the same techniques.
It is said that the market is in a trend only 30% of the time, while it consolidates or moves in a range 70% of the time.
Technical analysis clearly defines the prevailing market conditions. It allows traders to determine whether the market is in a rally, consolidation, or decline. Using this information, you can deploy the appropriate strategy to capitalize on the same.
Are you a technical trader?
I hope that after reading this blog post you get a decent idea about technical analysis and various types of this type of analysis.
Do let me know if you already trade using technical analysis or whether this blog post encouraged you to take up technical analysis trading.
Share this blog post with others and let them also be introduced to the world of technical analysis.
You can always reach out to me through the comments section for absolutely anything and I will get back to it at the earliest.