i. Technical analysis is a trading style in which traders only look at price and find trade opportunities.
ii. It further has its types and these types have their own strategies that can be traded.
What is technical analysis?
Whenever you trade, you need some reasons for the trade.
Some traders look at fundamentals and take trades based on this. Such traders are known as fundamental traders and this type of trading is based on fundamental analysis.
But, there are also traders that do not look at any such things and are just concerned with how price behaves. These are technical traders and this type of trading is what we call technical analysis.
Let’s consider this scenario, you are at a vegetable store looking to buy vegetables. You pick up all you want and see that the price is too high and you ask the vendor for a discount.
How do you know whether the price is high or low? How do you determine this? Well in the case of vegetable shopping, you will decide this based on how much you bought that particular vegetable the last time you went vegetable shopping.
Technical analysis is somewhat based on this principle. Technical analysts or traders that apply technical analysis look to study the price movement and try to forecast price (not predict) for the coming trading sessions.
There are certain tools that traders apply to study this data. These tools include candlestick patterns, chart patterns, value areas, technical indicators, etc.
All that technical traders do is that they see how price has moved in the past, how it is moving at the moment, and how it can move in the future and they use this to take trades.
Why technical analysis works? There are 3 principles of technical analysis that make it a type of analysis so sought after and proven to work.
1. Prices move in phases
Price will move in three ways, up, down, or sideways. This means that there could either be an uptrend, a downtrend, or a sideways or ranging price movement.
Now, the price will not always move in a particular phase all the time. There will be times when it changes phases and this change happens often.
Technical analysis allows traders to identify the phase the price is moving in at the moment and it assists them in developing strategies to capitalize on that particular price phase.
You can make money if the price is moving up, declining, and even if it is stuck in a range, all by using the methods of technical analysis.
2. History tends to repeat itself
If you have studied price charts then you will have come across price patterns and certain areas on the chart where the price tends to behave differently.
You can use this information and turn it into an edge, this is what technical traders do. But why would you do so? Because history tends to repeat itself.
If the price has behaved in a certain way in the past then there are possibilities of it behaving the same way sometime in the future.
What technical traders do is, study the conditions during the time price created such patterns and then they look for such developments in the future which gives them an indication that such a price pattern can get formed again.
This in itself is such a huge edge that traders make complete use of and make money.
3. Market discounts everything
The third and last principle of technical analysis, the markets discount everything.
We know that there are lots of factors that can affect price movements, these could be news releases, reports, a black swan event, etc.
The principle here is that the price of the financial assets already takes into consideration all that has happened, all that is happening, and all that might happen.
All these things are already factored in the price by the markets, hence the price is the only thing that matters to traders and they should only use this to take trades.
Types of technical analysis
Now that you know what technical analysis is, let’s explore the various types of technical analysis that traders make use of.
1. Price action
Price action is a type of technical analysis in which traders do not look at any indicator or anything, all that they look for is how the price is behaving.
It is the most naked form of analysis as all that price action requires is a price chart and the ability to identify and spot price patterns.
Traders that trade price action basically look for chart patterns and try to gain an edge and develop a bias for trades.
2. Technical indicators
Technical indicators are tools that are available to traders that they use to make trading decisions.
These indicators are basically a set of calculations that are applied to historical price movements and it gives an output on the basis of which traders can develop biases.
The technical indicators provide signals to trade and it tells the traders when to buy and when to sell.
3. Candlestick patterns
Candlesticks are a visual representation of the price. All that the price does is represented through candlesticks.
These candlesticks do not just provide information about price but also helps traders in taking trades.
There are certain candlestick patterns that have been observed to have been formed repeatedly over the years and it gives the trader an idea about what the price might do in the coming trading sessions.
I will explain candlesticks in a bit more detail further, so don’t skip any part.
How do technical analysts trade?
I have mentioned the theory you need to know regarding technical analysis and now I will discuss how you should apply this theory in actual trading.
Be attentive here as I am going to give you some actionable steps that you can apply right away and get ahead of the 90% of traders.
I. Figure out what the market is doing
Is the market trending or ranging?
Before taking any type of trade, a trader has to understand the conditions of the market and what exactly is going on in the market at that particular moment.
I have already mentioned that the market moves in phases of uptrend, downtrend, and range bound.
The first thing that every technical trader does, is to determine if the market is in an uptrend, downtrend, or is moving sideways.
If you just look at any price chart, it will be very clear whether the price is trending or if it is stuck in a range.
Tools for trending market
If you see that the price is moving in a single direction then you can use the swing highs and lows principle or even the trendline tool to establish the trend.
If the price is in an uptrend, then it will be forming a series of higher highs and higher lows, while in a downtrend, it will keep forming a series of lower lows and lower highs.
Trendlines are tools that are formed by plotting a line connecting two or more price points on the charts.
If the trendline is upward sloping, then the market is in an uptrend and if the trendline is downward sloping, then the market is in a downtrend.
Lots of traders look to establish trends by using the moving average indicator. On a smaller timeframe, you use any shorter moving average and on a longer timeframe, you can use a moving average with a longer time period.
Tools for ranging market
If you see that the price is moving sideways and appears to be stuck in a range, then you should look to identify and mark the value areas.
Value areas are levels on the price charts where the price had a very peculiar movement. Price could have tanked from this level or could have moved higher from it.
These are basically support and resistance price levels or zones that you must plot on price charts.
After marking these zones you should wait for the price to reach these levels and must confirm these levels by behaving accordingly.
II. Choose a trading strategy that you are comfortable with
After understanding what type of market you are in, you should then decide on what type of technical analysis you are going to follow to look for trading opportunities.
1. Price action
Price action, as mentioned earlier, is a type of technical analysis in which traders look to study the price behavior in the past and how it will reflect in the future.
Price action traders look for trendlines, support and resistance zones, and even chart patterns.
Chart patterns like flags, pennants, triangles, rectangles, head, and shoulders, double tops and bottoms, triple tops and bottoms, etc. form very often and it gives a trader a definite edge.
You can use these price action tools, trendlines, support and resistance zones, and chart patterns, to spot both price reversals and continuations.
For instance, you see that the price is in an uptrend and you plot a bullish trendline.
Every time the price falls back to the trendline and then moves back in the prevailing trend, you have a trend continuation and you can take trades accordingly.
But, if the price breaks the trendline and then moves in the opposite direction of the prevailing trend, then you have a price reversal taking place and can capitalize on this too.
2. Technical indicators
Technical indicators are additional tools that traders have access to which they can use to make trade decisions.
These indicators are tools that do the calculations for us and gives us trade signals. These signals are based on historical price data.
There are loads of indicators out there but it doesn’t mean that you have to try each and every one and decide which one works best.
You have to understand what each indicator represents and what problems it solves and then choose one.
The best indicators are the moving averages and the RSI. These indicators have been proven to work and you can create various strategies incorporating these indicators.
i. Moving average
Moving average, as the name suggests, provides an average of the price over the past time period. It is a good indicator for trend trading as it allows traders to spot trend formation and ride it.
Traders usually trade the moving average crossovers and the moving average price bounce or break.
A moving average crossover is when two moving averages, one of a shorter time period and the other of a longer time period, intersect each other at some point.
If the shorter moving average crosses the longer moving average to the upside, then it is a bullish signal and if it crosses it to the downside then it is a bearish signal.
Moving average price bounce is when the moving averages act as dynamic support or as a resistance to the price.
Moving average price breaks indicate trend reversals. If the price is above the moving average, it is a bullish sign. But once it breaks it to the downside, it is a bearish sign.
ii. Relative Strength Index
After the moving averages, we have the RSI which is a simple indicator that indicates whether the price is oversold or overbought.
The RSI values oscillate between 0 and 100 and if the reading is above 70, then the price is overbought and if it is below 30, then it is oversold.
Traders often use the RSI indicator to trade price divergences. Divergence is basically a mismatch between price and indicator.
Normally it is expected that the indicator replicates price movements and the readings of the indicators follow the price.
But at times it is observed that the price and the indicator have conflicting readings and this provides vital information to the traders.
So, in divergences, you will observe that if the price is making higher highs then the RSI values are making lower lows and vice versa.
In RSI divergence, the RSI readings reverse before the price actually reverses and it indicates a potential price reversal.
Hence, using the moving averages and the RSI indicator, you can spot both price reversals and continuations and can look to capitalize on both types of price movements.
I will elaborate on the practical uses of these indicators in the 4th step, so don’t miss out.
3. Candlestick patterns
Candlesticks are visual representations of the price movement. It shows what exactly the price did in that particular time period.
Candlesticks are made up of 4 things, open, high, low, and close. Candlesticks are of two types, bullish and bearish.
If the close of the candlestick is above the open, then it is bullish and if it is below the open then it is bearish.
The highs and lows of the price are represented by the wicks of the candlestick and it indicates how high and how low the price moved.
A single candlestick does not provide huge information, but traders can observe the size of the candlestick to determine strength.
A long candlestick shows strength while a short one shows weakness. A candlestick with little to no wicks again shows strength while long wicks show weakness.
There are certain candlestick patterns that are observed to have been formed repeatedly and it gives a lot of insight as to the future price movement.
Candlestick patterns like bullish and bearish engulfing, dojis, and pinbars are some of the widely followed patterns.
Bullish engulfing is when the second candlestick is a bullish one and its range is bigger than the first candlestick.
Bearish engulfing is when the second candlestick is a bearish one and its range is bigger than the first candlestick.
Dojis are basically indecision candlesticks and it indicates that neither the bulls nor the bears are in control.
The break of either side of the dojis indicates increasing strength in that particular direction.
A pinbar is a candlestick that has little to no wick on one side and has a relatively longer wick on the other side.
Pinbars are of two types, bullish and bearish, and depending on the location at which these pinbars are formed, traders can understand price behavior, take a bias, and eventually act on it by taking trades.
III. Entries and exits
After you have performed the 2 steps i.e. understood the market, developed a bias, and decided what type of technical analysis you are going to apply, you then have to look for entry opportunities.
The entries that you will take, has to be in the direction of the prevailing trend and the bias that you have developed. This is basically the trend-following approach.
Along with the entries, you also have to determine where exactly you will exit the trade and where your stop loss will be.
What I normally do is, once I know where to enter, I first mark the price level at which my stop loss should be, and then I look for the target price level.
This is one thing that very few traders do but is very crucial because we as traders should focus more on limiting risk rather than making a return.
Stop loss should be placed at such a level where your analysis would be completely invalidated.
As to the targets, you can have targets based on the RRR or can have specific price levels that you determine through your analysis.
It is very important that you write down your rules for entry, exit, and stop loss. You should have a clear-cut and definite set of rules and you should adhere to it at all times without fail.
For instance, your trading strategy is based on moving averages and the engulfing candlestick patterns.
So, your rules for entries would be such that, if the price is above the moving average then wait for the price to touch the moving average and let it form a bullish engulfing pattern.
Your entry here would be above the upper wick of the engulfing candlestick and stop loss will be just below the lower wick of the engulfing candlestick.
If you deviate from this plan then it shows that you lack discipline and you should work on that aspect if you want to make it big in trading.
IV. Bringing all the pieces together
Let’s put everything that I have taught you in the above 3 steps and consider some examples.
You apply the swing highs and lows approach and observe that the EURUSD currency pair is in an uptrend.
You then move ahead by using the price action approach and on the further observance of the price chart, you see a ranging forming and that the price of the EURUSD pair is stuck in this range.
You would then wait for the price to break out of this range, but in which direction? The upward direction, because the prevailing trend is bullish.
Once the price breaks the range to the upside, you will take an entry only when the candlestick closes above the range and your stop loss will be placed just below the lower end of the range.
Your target could be placed according to a 1:2 RRR or you could look to exit as and when price approaches a resistance level that lies in its path.
You observe the price of the NZDUSD currency pair and see that it is stuck between a range and you mark the support and resistance levels on the chart.
In such scenarios, you will wait for the price to hit either the support or the resistance, and then you have to observe what exactly it does around such areas.
Here, we will use the RSI indicator and we will look for the RSI divergence as and when the price reaches either end of the range.
In the chart of NZDUSD, you observe that the price reaches the support by making a series of swing lows but the RSI value is making higher highs, this is your signal for divergence.
Once you spot the divergence, you take an entry on the reversal candlestick and your stop loss will be placed just below the support.
Targets can be placed according to RRR or you can also exit once the price reaches the upper level of the range i.e. the resistance.
Let’s consider the USDCAD currency pair. You apply a 100 day moving average and see that the price is below it, you establish the bearish trend.
You will now wait for the price to approach the moving average and have to see how it behaves around it.
Price touches the moving average and bounces from it forming a bearish engulfing candlestick pattern. This is your signal to initiate a trade.
You will take an entry at the lower wick of the engulfing candlestick and your stop loss will be just above the trendline.
Targets again could be according to RRR and I would suggest having an RRR of at least 1:2, or you could even have other plans for exit.
When are you going to become a technical trader?
All that I have talked about in this blog post is everything you need to begin trading like a technical trader.
There are loads of information out there and it is all in a haphazard manner and not very precise and concise, but here is this blog post which is just that.
So, when are you going to become a technical trader and start trading based on these methods?
I would suggest that you apply these steps, either in the live market or even paper trading, but do apply it. Don’t just sit on this knowledge but take action right away.
Share this blog post with every trader you know and let them also reap the benefits from this.
Do reach out to me in case of any difficulties through the comments section and I will be more than willing to interact with you.