Technical analysis is the study of price movements using graphs, charts and indicators as your tools of analysis. In this article, we explain the basics, and how you can use the principles of technical analysis to help your trading.
While technical analysis can take many forms, at its most basic it is the study of past price movements using economic graphs. charts and technical indicators as the primary tools of analysis.
Utilising technical analysis properly involves undertaking a comparison between current price movements and historical price movements to attempt to identify trends which – in theory at least – can predict future price movements.
Advocates of technical analysis wholeheartedly believe in the efficacy of using historical price movements to identify future price movements. While this proposition is one which has been debated ad nauseam, what we can guarantee is that the successful application of technical analysis techniques should help traders of any skill-level and/or experience identify common trends and make purchases or sell based on easily-identifiable signals or indicators.
Types of Trader
In order to understand how to use graphs for analysis correctly, it is first important to be sure what classification of trader you fall within.
While there are many trading styles – trend following, profit scalping etc. – all traders fall within two distinct categories.
A short term trader is one who makes a habit of opening and closing positions within a very small amount of time, sometimes as short as five minutes and usually no longer than a week.
Technical analysis is the preferred tool used by short term traders for a number of reasons, but primarily because it generally takes a significant amount of time for factors like GDP or NFP releases to impact the market. This means that there isn’t much point using fundamental analysis to determine short term trends, because often those trends take time to develop.
Technical analysis, on the other hand, is perfect for use in volatile market conditions (like we are in currently) because – in theory – the principles of technical analysis can be applied to trends as they happen.
Short term traders often claim that they’re minimising their risk, because it allows them to generate the maximum possible return while assuming only limited exposure. This is a convincing argument, largely because price movements in short timeframes tend to be much less pronounced. For example, even an extremely sharp movement in the AUD/USD pair will hardly ever be more than 150-60 points in the course of 5-10 minutes.
However, it’s also worth noting that it can also be a lot harder to discern trends in such short spaces of time, and consequently most price action can appear random when viewed in minute-to-minute increments.
Some approaches used by short term traders include:
- Scalping: staying in the market for mere minutes at a time, attempting to profit from volatility while minimising potential risks.
- Day Trading: a popular strategy used in forex trading, as most traders choose to open their positions for less than a day at a time.
- Swing Trading: positions (generally small) are opened and closed over the period of a few days or a week at most. Slightly longer timeframe means less volatile range patterns and more predictable outcomes.
Long term traders, by contrast, are those who open investment positions and don’t close them for significant periods of time, perhaps as long as weeks, months or even years.
While it is nearly impossible to apply fundamental analysis in a situation where a position is only open for minutes or hours when positions are open for longer periods it is possible for a trader to choose to focus on either technical or fundamental techniques when formulating their investment strategy.
The major advantage of being a medium or long term trader is thus that it allows the trader to feel a degree of predictability. If the trader undertakes detailed technical or fundamental analysis it should be possible for them to have an indication of which way the market is headed without needing to put all their faith in trends.
Two of the most popular approaches used by long term traders are:
- Trend Following: the most common long term strategy, which involves a focus on the major current of the price action and either ignoring individual branches or taking advantage of them when appropriate. Generally, trends are created by fundamentals, however it is of course possible to exploit them using technical analysis as well.
- Carry Trade: a riskier method of following the trend which is much less reliant on fundamental analysis and also takes in to account interest income.
As you can see, while technical analysis is an important element of both short and long term trading strategies, it is essential – due to the inherent market volatility involved – that short term traders have an intimate understanding of basic technical analysis techniques.
Technical Analysis vs. Fundamental Analysis
Whether you prioritise technical or a fundamental analysis will be one of the hardest choices you make as an investor starting out in the market.
Technical analysts, as we have outlined, are advocates for the idea that the best approach to the market is to always follow the trends.
Fundamental analysts, on the other hand, believe that the market as it currently sits at any given point may be overlooking value, which is to be found by digging through a company’s balance sheet or perusing its recent announcements.
There is no one answer as to what is the best approach to take. There are numerous examples of successful investors who have employed either technical or fundamental analysis to their benefit, and numerous examples of those who have used both. It’s all a matter of personal preference.
In general, though, technical analysis does lend itself more towards those who operate at a faster investing pace, whereas fundamental analysis is more for those who favour a slower-burn with their portfolio.
The primary principle underpinning technical analysis is that a given market price is reflective of all of the available contemporary information that could possibly impact that given market.
Hence, die-hard advocates of technical analysis believe that there’s no use paying any attention at all to unfolding economic, political or fundamental events because, in theory at least, those events have already been factored in to the price of the market.
Technical analysts instead place all of their faith in to the belief that the market moves in trends, and that the market’s overall movement is based on determinable factors like the historical behavior of investors.
It is thus essential for a technical analyst to be able to plot these trends and historical movements on to graphs and understand what those graphs mean in order to to determine areas of support and resistance.
The ability to identify areas of support and resistance on charts is what allows technical analysts to predict where a market is headed and thus take advantage of either a falling or a rising price.
There are three major types of graphs
Line graphs are the most frequently used to represent changes in value over time, whether that’s in securities, major stock indexes or company revenue sheets.
Importantly for technical analysts, line graphs show the line from one closing price to another closing price of another day.
Used correctly, they can be used to determine the overall price direction of an instrument over a period of time.
A bar graph provides more insights than the line chart by showing both the opening and closing prices of each day (or any given period).
A candlestick chart shows opening and closing prices, including the highest and lowest price of any specified period.
The graph looks like a candle, which makes it easily interpretable and allows technical analysts to identify a price trend more easily.
Along with graphs/charts, technical/statistical indicators are the other primary method used by technical analysts to try and gain an advantage on the market.
The term “technical indicators” specifically refers to a form of technical analysis where a series of mathematical forums and theorems are applied to a set of financial data, with the aim of producing a recognisable trend in that data.
Technical indicators focus largely on historical trading data, for example, volume, open interest, price etc. rather than more fundamental things like earnings or revenue. They can be used on any financial instrument with historical data behind it, so feel free to use technical indicators on stocks, commodities, currencies and everything in between.
There are two fundamental varieties of technical indicators.
Overlays are essentially indicators that are plotted on the same scale as prices are and consequently, sit over the top of prices on a stock chart.
Examples of overlays include Bollinger Bands and moving averages.
Oscillators are a form of technical indicator which oscillate (hence the name) between a local minimum and maximum and are plotted above or below a price chart.
Examples of oscillators include MACD (Moving Average Convergence Divergence), stochastic oscillator or RSI.
Technical Analysis Limitations
As with all stock market strategies, technical analysis, of course, has many limitations, which is important to be aware before jumping in headfirst.
Interpretation of charts is the key to technical analysis, so it stands to reason that even the slightest misinterpretation of chart or data can result in a fatal flaw in your hypothesis. Similarly, technical indicators are based on stringent formulas, and the misapplication or miscalculation of those formulas can undermine your predictions.
Most interesting, though, is the idea that the more technical analysis is used by investors the more it becomes harder and harder to apply correctly. For example, every technical analyst should be asking themselves when a trend presents: “is this formation appearing because my technical analysis shows this is what should be happening, or is it because every trader’s analysis is showing this is what should be happening and they are all behaving accordingly?”
In the end, though, a true technical analyst doesn’t mind how the trend occurs; all that matters is that their model for trading continues to show results.