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INTRODUCTION TO TECHNICAL ANALYSIS
Technical analysis is a method of forecasting price movements by looking at purely market-generated data. Price data from a particular market is most commonly the type of information analyzed by a technician, though most will also keep a close watch on volume and open interest in futures contracts. The bottom line when utilizing any type of analytical method, technical or otherwise, is to stick to the basics, which are methodologies with a proven track record over a long period.
Almost every trader uses some form of technical analysis. Even the most reverent follower of market fundamentals is likely to glance at price charts before executing a trade. At their most basic level, these charts help traders determine ideal entry and exit points for a trade. They provide a visual representation of the historical price action of whatever is being studied. As such, traders can look at a chart and know if they are buying at a fair price (based on the price history of a particular market), selling at a cyclical top or perhaps throwing their capital into a choppy, sideways market. These are just a few market conditions that charts identify for a trader.
It might appear that technicians ignore the fundamentals of the market while surrounding themselves with charts and data tables. However, a technical trader will tell you that all of the fundamentals are already represented in the price. They are not so much concerned that a natural disaster or an awful inflation number caused a recent spike in prices as much as how that price action fits into a pattern or trend and how that pattern can be used to predict future prices.
The Basic Tenets
Technical analysis is best defined as the use of charts in order to study price activity. The ultimate objective is to use this information in order to attempt to forecast future price trends.
Key tenets that underpin the technical approach include the following:
- Market prices move in trends.
- Market action reflects all known information that is available.
- The past predictive value of price patterns that reflect the bullish or bearish psychology of the marketplace are assumed to apply in the future.
Technicals Versus Fundamentals
There are often many instances when technicals are compared and contrasted with the fundamentals. Table 1 provides a brief comparative synopsis of the two disciplines.
Neither discipline is correct at forecasting price moves 100% of the time. Table 2 addresses the pros and cons of technical analysis in this regard.
While both approaches are often used to some degree by market participants, they tend to differ at the beginning of major market moves because market prices tend to lead the known fundamentals. Even for those who tend to rely on fundamental analysis to make their trading decisions, the technicals are often employed as an executional tool to highlight key support and resistance levels and to establish risk/ reward parameters for proposed trading strategies.
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Comparison of Technical Versus Fundamental Analysis
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| Technical Analysis: |
Fundamental Analysis: |
| 1) The study of price activity in an attempt to predict trends. |
1) The study of supply and demand in order to determine intrinsic value. |
| 2) Instruments in an uptrend are candidates to be purchased; instruments in a downtrend are candidates to be sold. |
2) Instruments that are below intrinsic value are deemed undervalued and are candidates to be purchased; instruments that are above intrinsic value are deemed overvalued and are candidates to be sold. |
| 3) The technician studies the anticipated effect of price movements. |
3) The fundamentalist studies the cause of price movements. |
| 4) Attempts to measure the projected effects of price moves. |
4) Attempts to ascertain why prices have moved. |
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Technical Analysis: Pros and Cons
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| Pros: |
Cons: |
| Can be applied to all instruments that are traded. |
May be a “self-fulfilling prophecy”. |
| Applicable to any time horizon (short, medium and long-term). |
Chart analysis can be subjective at times. |
| Established framework allows diverse markets to be followed at once. |
Not effective in consolidating or non-trending markets. |
| Permits the focus on trending markets, as opposed to markets that are not “moving”. |
False breakouts can produce erroneous trading signals. |
Technical analysis assumes that:
• All market fundamentals are depicted in the actual market data.
So the actual market fundamentals and various factors, such as the differing opinions, hopes, fears, and moods of market participants, need not be studied.
• History repeats itself and therefore markets move in fairly predictable, or at least quantifiable, patterns. These patterns, generated by price movement, are called signals. The goal in technical analysis is to uncover the signals given off in a current market by examining past market signals.
• Prices move in trends. Technicians typically do not believe that price fluctuations are random and unpredictable. Prices can move in one of three directions, up, down or sideways. Once a trend in any of these directions is established, it usually will continue for some period. The building blocks of any technical analysis system include price charts, volume charts, and a host of other mathematical representations of market patterns and behaviours. Most often called studies, these mathematical manipulations of various types of market data are used to determine the strength and sustainability of a particular trend. So, rather than simply relying on price charts to forecast future market values, technicians will also use a variety of other technical tools before entering a trade.
As in all other aspects of trading, it is required to be very disciplined when using technical analysis. Too often, a trader will fail to sell or buy into a market even after it has reached a price that his or her technical studies identified as an entry or exit point. This is because it is hard to screen out the fundamental realities that led to the price movement in the first place. As an example, let's assume you are long Euro vs. USD and have established your stop/loss 30 pips away from your entry point. However, if some unforeseen factor is responsible for pushing the USD through your stop/loss level you might be inclined to hold this position just a bit longer in the hopes that it turns back into a winner. It is very hard to make the decision to cut your losses and even harder to resist the temptation to book profits too early on a winning trade. This is called leaving money on the table. A common mistake is to ride a loser too long in the hopes it comes back and to cut a winner way too early. If technical analysis is utilized to establish entry and exit levels, be very disciplined in following through on the original trading plan.
PRICE CHARTS
Chart patterns
There are a variety of charts that show price action. The most common are bar charts. Each bar will represent one period of time and that period can be anything from one minute to one month to several years. These charts will show distinct price patterns that develop over time.
Candlestick patterns
Like bar charts patterns, candlestick patterns can be used to forecast the market. Because of their colored bodies, candlesticks provide greater visual detail in their chart patterns than bar charts.
TECHNICAL INDICATORS
Here are a few of the more common types of indicators used in technical analysis:
Trend indicators
Trend is a term used to describe the persistence of price movement in one direction over time. Trends move in three directions: up, down and sideways. Trend indicators smooth variable price data to create a composite of market direction. (Example: Moving Averages, Trend lines)
Strength indicators
Market strength describes the intensity of market opinion with reference to a price by examining the market positions taken by various market participants. Volume or open interest are the basic ingredients of this indicator. Their signals are coincident or leading the market. (Example: Volume)
Volatility indicators
Volatility is a general term used to describe the magnitude, or size, of day-to-day price fluctuations independent of their direction. Generally, changes in volatility tend to lead changes in prices. (Example: Bollinger Bands)
Cycle indicators
A cycle is a term to indicate repeating patterns of market movement, specific to recurrent events, such as seasons, elections, etc. Many markets have a tendency to move in cyclical patterns. Cycle indicators determine the timing of a particular market patterns. (Example: Elliott Wave)
Support/resistance indicators
Support and resistance describes the price levels where markets repeatedly rise or fall and then reverse. This phenomenon is attributed to basic supply and demand. (Example: Trend Lines)
Momentum indicators
Momentum is a general term used to describe the speed at which prices move over a given time period. Momentum indicators determine the strength or weakness of a trend as it progresses over time. Momentum is highest at the beginning of a trend and lowest at trend turning points. Any divergence of directions in price and momentum is a warning of weakness; if price extremes occur with weak momentum, it signals an end of movement in that direction. If momentum is trending strongly and prices are flat, it signals a potential change in price direction. (Example: Stochastic, MACD, RSI)
The Basis of Technical Analysis explains trend analysis and how to use basic trend following techniques.
MARKET TREND
Trend is simply the overall direction prices are moving -- UP, DOWN, OR FLAT.
TYPES OF TRENDS
The direction of the trend is absolutely essential to trading and analyzing the market. In the Foreign Exchange (FX) Market, it is possible to profit from UP and Down movements, because of the buying and selling of one currency and against the other currency e.g. Buy US Dollar Sell Japanese Yen.
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Up Trend
As the trend moves upwards the US Dollar is appreciating
in value. |
Down Trend
As the trend moves downwards the US Dollar is depreciating
in value. |
Sideways Trend
Prices are moving within a narrow Range. The currencies are neitherappreciating nor depreciating. |
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Trend Classifications
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Short-term or minor trends:
Medium-term or intermediate trends:
Long-term or major trends:
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Up to 4 weeks in duration
One to three months in duration
Greater than six months in duration |
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