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Technical Analysis – How To Analyse Financial Markets
Technical analysis is the best way of predicting short-term price movements. For binary options traders, the use of technical analysis is without alternative. To help you create your own successful technical analysis strategy, this article will explain the basics of technical analysis and its use in binary options trading.
In this article, you will learn:
- What Is Technical Analysis?
- Why Do Traders Use Technical Analysis?
- Should Binary Options Traders Use Technical Analysis?
- What Could A Technical Analysis Strategy Look Like?
With this information, you will be able to understand the logic behind technical analysis and use a technical analysis strategy to trade binary options.
What Is Technical Analysis?
Technical analysis is a way of understanding what has happened to the price of an asset and predicting what will happen to it next. The unique characteristic of technical analysis is that it focuses solely on price movements.
When they analyse a stock, for example, technical analysis ignore everything about the company behind the stock. They are not interested in its earnings, nor its economic future, nor the quality of its products. All they look at is what its stock price has done in the past and which implications this history allows for the future.
Technical analysis is based on a simple assumption: everything that you can know about a stock is already factored into its price. By looking at the price, you can learn everything about a stock, and you can learn a lot more than with any other form of analysis.
Predicting Financial Markets
For example, assume that you are supposed to predict how many people go into buildings every day. You know that thousands of people a day went into a building for a year. You also know that only two or three people a day went into the building next to it. This knowledge is all you need to predict that more people will go into the first building than into the second.
This process is exactly how technical analysis works. It focuses solely on the thing you are trying to predict and ignores the reason behind it.
In the building example, the first building might be a train station and the second one a small house. You could spend a lot of time gathering this type of knowledge, but what good would it do you? It would only tell you what you already know from looking at the numbers alone.
But if there are two small houses, what do you predict now? You would need to find out which house houses a family and which a single person, which of them has more friends, and so on – an endless task that would never get you all the information.
Alternatively, you could also analyse how many people went into each house in the past.
- If the relationship is 10 to 2, you know what you have to predict. Likely, more people will go into the house with the 10-people average.
- If the relationship is 5 to 4, you could think that this one is too risky to predict and analyse the next houses.
Technical analysis adapts this philosophy to financial investments.
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- If the price of an asset currently is rising, it is unimportant to understand why. The fact that it is rising tells you everything you need to know to make a good investment.
- If the price of an asset currently is falling, it is unimportant to understand why. The fact that it is falling tells you everything you need to know to make a good investment.
Technical analysis follow this principle and also allows you to analyse many characteristics
Why Do Traders Use Technical Analysis?
When traders of all types analyse the market, they have two options. They can use:
- Technical analysis, and
- Fundamental analysis.
We have already explained what technical analysis is. Fundamental analysis is the prediction of price movements based on economic data, earnings, and other indicators of a stock’s, commodity’s, or currency’s future.
Fundamental analysis assumes that there is a direct connection between these values and the price of an asset. While the market often fails to reflect this connection right now, fundamental analysts assume that the price will eventually adjust to these factors.
There are several good reasons why traders choose technical analysis over fundamental analysis.
There Are Many Things That Are Impossible To Quantify
For example, the electric car company Tesla is valued at a much higher price than many other car makers in the world. This is despite the fact that Tesla has never turned a profit and only sells a fraction of the cars that other companies sell.
How do you justify this price based on technical analysis? Many people buy Tesla because they like Elon Musk, and because they think that electric cars are the future. But why do so many people put so much more trust in Elon Musk than in other managers? After all, they never heard of most of these other managers, so how can they mistrust them?
Trust is one of the many things that are impossible to quantify. If traders trust a CEO, does that mean Tesla should trade at £50, £500, or £1,000?
Fundamentals Do Not Show Whole Picture
There are many other things that are impossible to quantify. Coca-Cola seems to have an advantage over Pepsi but why? Google has an advantage over Yahoo, Mercedes-Benz over Renault, and so on. How do you quantify image and similar soft criteria?
With technical analysis, you can avoid such impossible decisions. When the stock of Coca-Cola is worth two times more than the stock of Pepsi, traders apparently quantify the value of the stock twice as high. If the gap is increasing, you know how to invest. There is no need to understand why.
With fundamental analysis, such simple investment decisions are impossible.
Which Market Influence Will Be Strongest?
Regardless of how much data a fundamental analyst gathers, they can never paint a complete picture of a stock’s worth. As we already pointed out, there are many factors that are impossible to quantify and therefore inaccessible to fundamental analysis.
Additionally, even the quantifiable factors are too numerous to consider them all, and it is impossible to predict which factor will influence the price the strongest.
For example, assume these scenarios:
- You are looking at the stock of a company whose profit has increased, but its sales have decreased. Which factor will be more important to traders?
- You are looking at the stock index of a country who has had an increase in open jobs and an increase in unemployment. Which factor will be more important to traders?
- You are looking at the stock of a company that has cut 1,000 jobs. The savings could make the company more profitable, but it could also be a sign that the company is in trouble. Which factor will be more important to traders?
In hindsight, these questions are easy to answer. There are often cases in which so-called experts on news networks predict that if the central bank decreases the base rate by 0.5 percent, stocks will rise. But when the central bank does exactly that, stocks fall. In the evening, the same analysts will say that traders apparently expected even more – which is easy to say in hindsight, but impossible to predict.
Traders have to make a prediction in advance, which is why they have to avoid letting the perfect vision of hindsight analysis trick them into assuming the same clarity for the future. The future is a much more unpredictable place, and it is impossible to predict which fundamental factors will dominate the price of an asset.
Technical analysts never ask why something happens. Therefore, they can avoid having to predict how the market will react to specific influence and which of these influences will dominate. They can sit back, wait for the market to show its hand, and then go with what they know instead of relying on their best guess.
Only Technical Analysis Can Make Short-Term Predictions
Maybe the biggest problem of fundamental analysis is that it is incapable of making short-term predictions.
Even if you knew everything about an asset, if you knew what will affect the asset and how it will affect it, you would only be able to predict how this asset will do over the next year or longer. You would be unable to use this knowledge to create short-term predictions, for example whether the price will fall over the next hour or the next day.
Very often, there are no fundamental influences on an asset. Quarterly reports are only released all three months, and in between, there can be weeks of quiet. Despite this lack of fundamental influences, almost all new stocks create a new price every second or even more often.
Fundamental analysis is incapable of explaining how these small movements come about and predicting how they will develop.
What Moves Asset Prices?
The truth is that most market movements are the result of random events.
- When a large index fund decides to replace one stock with another, it has to sell off the first stock and buy the second one. Since selling such large positions all at once would lead to an immense sudden price rise or fall, funds sell and other large institutional investors buy and sell stocks in many small packages. These phases can take weeks or months, during which the investor constantly pushes the price in the same direction. Only technical analysis can recognize the consequences of these events and recommend the right investment decisions.
- When a single person decides to buy or sell an asset, they rarely wait for the fundamental data to change. When they get a birthday present, an inheritance, or a raise, they buy. When they need money to repair the car, they sell. Fundamental analysis is incapable of predicting these movements that influence shorter time frames. Technical analysis can understand their effects and predict what they mean for the future.
All other market movements result from similar random influences. Only technical analysis can help you understand how these movements will play out.
Should Binary Options Traders Use Technical Analysis?
For binary options traders, the use of a strategy based on technical analysis is almost without alternative. Let’s analyse the reasons for this statement first and then take a look at the only exception.
- Binary options are short-term investments, and only technical analysis can create valid short-term predictions.
- Binary options require you to make many trades. Because binary options use short expiries of a few minutes to a few hours, you can easily make ten or more trades a day. Only technical analysis allows you to make this many trades. Fundamental analysis would require you to find out everything about a company, country, or commodity before you invest – which is simply impossible to do ten times a day.
- Binary options require you to be quick. On the short time scales of binary options, opportunities come and go within minutes. If you tried to perform fundamental analysis in this time, the opportunity would be long gone before you are done. Technical analysis enables you to take the time in advance and define a strategy that allows you to make a decision within seconds.
The only exception to these points is a single fundamental strategy that can work with binary options: trading the news. When important news is scheduled to hit the market, you know that they will result in a short, strong movement. Binary options are the ideal tool to trade these movements.
Even in this case, however, technical analysis can be helpful to predict how far the resulting movement can move and when it will end.
Summary On Technical Analysis
Technical analysis is the best and only way of predicting short-term market movements. For binary options traders, using a strategy based on technical analysis is almost without alternative – the only exception would be a news trading strategy.
Technical analysis focuses solely on price movements. This is the only way to understand how other traders feel about an asset because the infinite amount of influences is impossible to categorize and interpret by fundamental analysis.
If you are a binary options trader, use technical analysis. If you still lack the right broker to execute this strategy, take a look at our broker top list.
Technical Analysis – A Beginner’s Guide
What is Technical Analysis?
Technical analysis is a tool, or method Valuation Methods When valuing a company as a going concern there are three main valuation methods used: DCF analysis, comparable companies, and precedent transactions. These methods of valuation are used in investment banking, equity research, private equity, corporate development, mergers & acquisitions, leveraged buyouts and finance , used to predict the probable future price movement of a security – such as a stock Stock What is a stock? An individual who owns stock in a company is called a shareholder and is eligible to claim part of the company’s residual assets and earnings (should the company ever be dissolved). The terms “stock”, “shares”, and “equity” are used interchangeably. or currency pair – based on market data.
The theory behind the validity of technical analysis is the notion that the collective actions – buying and selling – of all the participants in the market accurately reflect all relevant information pertaining to a traded security, and therefore, continually assign a fair market value to the security Public Securities Public securities, or marketable securities, are investments that are openly or easily traded in a market. The securities are either equity or debt-based. .
Past Price as an Indicator of Future Performance
Technical traders believe that current or past price action in the market is the most reliable indicator of future price action.
Technical analysis is not only used by technical traders. Many fundamental traders use fundamental analysis Analysis of Financial Statements How to perform Analysis of Financial Statements. This guide will teach you to perform financial statement analysis of the income statement, balance sheet, and cash flow statement including margins, ratios, growth, liquiditiy, leverage, rates of return and profitability. to determine whether to buy into a market, but having made that decision, then use technical analysis to pinpoint good, low-risk buy entry price levels.
Charting on Different Time Frames
Technical traders analyze price charts to attempt to predict price movement. The two primary variables for technical analysis are the time frames considered and the particular technical indicators that a trader chooses to utilize.
The technical analysis time frames shown on charts range from one-minute to monthly, or even yearly, time spans. Popular time frames that technical analysts most frequently examine include:
- 5-minute chart
- 15-minute chart
- Hourly chart
- 4-hour chart
- Daily chart
The time frame a trader selects to study is typically determined by that individual trader’s personal trading style. Intra-day traders, traders who open and close trading positions within a single trading day, favor analyzing price movement on shorter time frame charts, such as the 5-minute or 15-minute charts. Long-term traders who hold market positions overnight and for long periods of time are more inclined to analyze markets using hourly, 4-hour, daily, or even weekly charts.
Price movement that occurs within a 15-minute time span may be very significant for an intra-day trader who is looking for an opportunity to realize a profit from price fluctuations occurring during one trading day. However, that same price movement viewed on a daily or weekly chart may not be particularly significant or indicative for long-term trading purposes.
It’s simple to illustrate this by viewing the same price action on different time frame charts. The following daily chart for silver shows price trading within the same range, from roughly $16 to $18.50, that it’s been in for the past several months. A long-term silver investor might be inclined to look to buy silver based on the fact that the price is fairly near the low of that range.
However, the same price action viewed on an hourly chart (below) shows a steady downtrend that has accelerated somewhat just within the past several hours. A silver investor interested only in making an intra-day trade would likely shy away from buying the precious metal based on the hourly chart price action.
Candlestick charting is the most commonly used method of showing price movement on a chart. A candlestick is formed from the price action during a single time period for any time frame. Each candlestick on an hourly chart shows the price action for one hour, while each candlestick on a 4-hour chart shows the price action during each 4-hour time period.
Candlesticks are “drawn” / formed as follows: The highest point of a candlestick shows the highest price a security traded at during that time period, and the lowest point of the candlestick indicates the lowest price during that time. The “body” of a candlestick (the respective red or blue “blocks”, or thicker parts, of each candlestick as shown in the charts above) indicates the opening and closing prices for the time period. If a blue candlestick body is formed, this indicates that the closing price (top of the candlestick body) was higher than the opening price (bottom of the candlestick body); conversely, if a red candlestick body is formed, then the opening price was higher than the closing price.
Candlestick colors are arbitrary choices. Some traders use white and black candlestick bodies (this is the default color format, and therefore the one most commonly used); other traders may choose to use green and red, or blue and yellow. Whatever colors are chosen, they provide an easy way to determine at a glance whether price closed higher or lower at the end of a given time period. Technical analysis using a candlestick charts is often easier than using a standard bar chart, as the analyst receives more visual cues and patterns.
Candlestick Patterns – Dojis
Candlestick patterns, which are formed by either a single candlestick or by a succession of two or three candlesticks, are some of the most widely used technical indicators for identifying potential market reversals or trend change.
Doji candlesticks, for example, indicate indecision in a market that may be a signal for an impending trend change or market reversal. The singular characteristic of a doji candlestick is that the opening and closing prices are the same, so that the candlestick body is a flat line. The longer the upper and/or lower “shadows”, or “tails”, on a doji candlestick – the part of the candlestick that indicates the low-to-high range for the time period – the stronger the indication of market indecision and potential reversal.
There are several variations of doji candlesticks, each with its own distinctive name, as shown in the illustration below.
The typical doji is the long-legged doji, where price extends about equally in each direction, opening and closing in the middle of the price range for the time period. The appearance of the candlestick gives a clear visual indication of indecision in the market. When a doji like this appears after an extended uptrend or downtrend in a market, it is commonly interpreted as signaling a possible market reversal, a trend change to the opposite direction.
The dragonfly doji, when appearing after a prolonged downtrend, signals a possible upcoming reversal to the upside. Examination of the price action indicated by the dragonfly doji explains its logical interpretation. The dragonfly shows sellers pushing price substantially lower (the long lower tail), but at the end of the period, price recovers to close at its highest point. The candlestick essentially indicates a rejection of the extended push to the downside.
The gravestone doji’s name clearly hints that it represents bad news for buyers. The opposite of the dragonfly formation, the gravestone doji indicates a strong rejection of an attempt to push market prices higher, and thereby suggests a potential downside reversal may follow.
The rare, four price doji, where the market opens, closes, and in-between conducts all buying and selling at the exact same price throughout the time period, is the epitome of indecision, a market that shows no inclination to go anywhere in particular.
There are dozens of different candlestick formations, along with several pattern variations. Probably the most complete resource for identifying and utilizing candlestick patterns is Thomas Bulkowski’s pattern site, which thoroughly explains each candlestick pattern and even provides statistics on how often each pattern has historically given a reliable trading signal. It’s certainly helpful to know what a candlestick pattern indicates – but it’s even more helpful to know if that indication has proven to be accurate 80% of the time.
Technical Indicators – Moving Averages
In addition to studying candlestick formations, technical traders can draw from a virtually endless supply of technical indicators to assist them in making trading decisions.
Moving averages are probably the single most widely-used technical indicator. Many trading strategies utilize one or more moving averages. A simple moving average trading strategy might be something like, “Buy as long as price remains above the 50-period exponential moving average (EMA); Sell as long as price remains below the 50 EMA”.
Moving average crossovers are another frequently employed technical indicator. A crossover trading strategy might be to buy when the 10-period moving average crosses above the 50-period moving average.
The higher a moving average number is, the more significant price movement in relation to it is considered. For example, price crossing above or below a 100- or 200-period moving average is usually considered much more significant than price moving above or below a 5-period moving average.
Technical Indicators – Pivots and Fibonacci Numbers
Daily pivot point indicators, which usually also identify several support and resistance levels in addition to the pivot point, are used by many traders to identify price levels for entering or closing out trades. Pivot point levels often mark significant support or resistance levels or the levels where trading is contained within a range. If trading soars (or plummets) through the daily pivot and all the associated support or resistance levels, this is interpreted by many traders as “breakout” trading that will shift market prices substantially higher or lower, in the direction of the breakout.
Daily pivot points and their corresponding support and resistance levels are calculated using the previous trading day’s high, low, opening and closing prices. I’d show you the calculation, but there’s really no need, as pivot point levels are widely published each trading day and there are pivot point indicators you can just load on a chart that do the calculations for you and reveal pivot levels. Most pivot point indicators show the daily pivot point along with three support levels below the pivot point and three price resistance levels above it.
Fibonacci levels are another popular technical analysis tool. Fibonacci was a 12 th -century mathematician who developed a series of ratios that is very popular with technical traders. Fibonacci ratios, or levels, are commonly used to pinpoint trading opportunities and both trade entry and profit targets that arise during sustained trends.
The primary Fibonacci ratios are 0.24, 0.38, 0.62, and 0.76. These are often expressed as percentages – 23%, 38%, etc. Note that Fibonacci ratios complement other Fibonacci ratios: 24% is the opposite, or remainder, of 76%, and 38% is the opposite, or remainder, of 62%.
As with pivot point levels, there are numerous freely available technical indicators that will automatically calculate and load Fibonacci levels onto a chart.
Fibonacci retracements are the most often used Fibonacci indicator. After a security has been in a sustained uptrend or downtrend for some time, there is frequently a corrective retracement in the opposite direction before price resumes the overall long-term trend. Fibonacci retracements are used to identify good, low-risk trade entry points during such a retracement.
For example, assume that the price of stock “A” has climbed steadily from $10 to $40. Then the stock price begins to fall back a bit. Many investors will look for a good entry level to buy shares during such a price retracement.
Fibonacci numbers suggest that likely price retracements will extend a distance equal to 24%, 38%, 62%, or 76% of the uptrend move from $10 to $40. Investors watch these levels for indications that the market is finding support from where price will begin rising again. For example, if you were hoping for a chance to buy the stock after approximately a 38% retracement in price, you might enter an order to buy around the $31 price level. (The move from $10 to $40 = $30; 38% of $30 is $9; $40 – $9 = $31)
Continuing with the above example – So now you’ve bought the stock at $31 and you’re trying to determine a profit target to sell at. For that, you can look to Fibonacci extensions, which indicate how much higher price may extend when the overall uptrend resumes. The Fibonacci extension levels are pegged at prices that represent 126%, 138%, 162%, and 176% of the original uptrend move, calculated from the low of the retracement. So, if a 38% retracement of the original move from $10 to $40 turns out to be the retracement low, then from that price ($31), you find the first Fibonacci extension level and potential “take profit” target by adding 126% of the original $30 move upward. The calculation goes as follows:
Fibonacci extension level of 126% = $31 + ($30 x 1.26) = $68 – giving you a target price of $68.
Once again, you never actually have to do any of these calculations. You just plug a Fibonacci indicator into your charting software and it displays all the various Fibonacci levels.
Pivot and Fibonacci levels are worth tracking even if you don’t personally use them as indicators in your own trading strategy. Because so many traders do base buying and selling moves on pivot and Fibonacci levels, if nothing else there is likely to be significant trading activity around those price points, activity that may help you better determine probable future price moves.
Technical Indicators – Momentum Indicators
Moving averages and most other technical indicators are primarily focused on determining likely market direction, up or down.
There is another class of technical indicators, however, whose main purpose is not so much to determine market direction as to determine market strength. These indicators include such popular tools as the Stochastic Oscillator, the Relative Strength Index (RSI), the Moving Average Convergence-Divergence (MACD) indicator, and the Average Directional Movement Index (ADX).
By measuring the strength of price movement, momentum indicators help investors determine whether current price movement more likely represents relatively insignificant, range-bound trading or an actual, significant trend. Because momentum indicators measure trend strength, they can serve as early warning signals that a trend is coming to an end. For example, if a security has been trading in a strong, sustained uptrend for several months, but then one or more momentum indicators signals the trend steadily losing strength, it may be time to think about taking profits.
The 4-hour chart of USD/SGD below illustrates the value of a momentum indicator. The MACD indicator appears in a separate window below the main chart window. The sharp upturn in the MACD beginning around June 14 th indicates that the corresponding upsurge in price is a strong, trending move rather than just a temporary correction. When price begins to retrace downward somewhat on the 16 th , the MACD shows weaker price action, indicating that the downward movement in price does not have much strength behind it. Soon after that, a strong uptrend resumes. In this instance, the MACD would have helped provide reassurance to a buyer of the market that (A) the turn to the upside was a significant price move and (B) that the uptrend was likely to resume after price dipped slightly on the 16 th .
Because momentum indicators generally only signal strong or weak price movement, but not trend direction, they are often combined with other technical analysis indicators as part of an overall trading strategy.
Technical Analysis – Conclusion
Keep in mind the fact that no technical indicator is perfect. None of them gives signals that are 100% accurate all the time.
The smartest traders are always watching for warning signs that signals from their chosen indicators may be misleading. Technical analysis, done well, can certainly improve your profitability Profitability Ratios Profitability ratios are financial metrics used by analysts and investors to measure and evaluate the ability of a company to generate income (profit) relative to revenue, balance sheet assets, operating costs, and shareholders’ equity during a specific period of time. They show how well a company utilizes its assets to produce profit as a trader. However, what may do more to improve your fortunes in trading is spending more time and effort thinking about how best to handle things if the market turns against you, rather than just fantasizing about how you’re going to spend your millions.
What Is Technical Analysis?
Technical analysis is a trading discipline employed to evaluate investments and identify trading opportunities by analyzing statistical trends gathered from trading activity, such as price movement and volume.
Unlike fundamental analysis, which attempts to evaluate a security’s value based on business results such as sales and earnings, technical analysis focuses on the study or price and volume. Technical analysis tools are used to scrutinize the ways supply and demand for a security will affect changes in price, volume and implied volatility. Technical analysis is often used to generate short-term trading signals from various charting tools, but can also help improve the evaluation of a security’s strength or weakness relative to the broader market or one of its sectors. This information helps analysts improve there overall valuation estimate.
Technical analysis can be used on any security with historical trading data. This includes stocks, futures, commodities, fixed-income, currencies, and other securities. In this tutorial, we’ll usually analyze stocks in our examples, but keep in mind that these concepts can be applied to any type of security. In fact, technical analysis is far more prevalent in commodities and forex markets where traders focus on short-term price movements.
- Technical analysis is a trading discipline employed to evaluate investments and identify trading opportunities in price trends and patterns seen on charts.
- Technical analysts believe past trading activity and price changes of a security can be valuable indicators of the security’s future price movements.
- Technical analysis may be contrasted with fundamental analysis, which focuses on a company’s financials rather than historical price patterns or stock trends.
Understanding Fundamental Vs. Technical Analysis
The Basics Of Technical Analysis
Technical analysis as we know it today was first introduced by Charles Dow and the Dow Theory in the late 1800s. Several noteworthy researchers including William P. Hamilton, Robert Rhea, Edson Gould, and John Magee further contributed to Dow Theory concepts helping to form its basis. In modern day, technical analysis has evolved to included hundreds of patterns and signals developed through years of research.
Technical analysis operates from the assumption that past trading activity and price changes of a security can be valuable indicators of the security’s future price movements when paired with appropriate investing or trading rules. Professional analysts often use technical analysis in conjunction with other forms of research. Retail traders may make decisions based solely on the price charts of a security and similar statistics, but practicing equity analysts rarely limit their research to fundamental or technical analysis alone.
Among professional analysts, the CMT Association supports the largest collection of chartered or certified analysts using technical analysis professionally around the world. The association’s Chartered Market Technician (CMT) designation can be obtained after three levels of exams that cover both a broad and deep look at technical analysis tools. Nearly one third of CMT charter holders are also Certified Financial Analyst (CFA) charter holders. This demonstrates how well the two disciplines reinforce each other.
The Underlying Assumptions of Technical Analysis
There are two primary methods used to analyze securities and make investment decisions: fundamental analysis and technical analysis. Fundamental analysis involves analyzing a company’s financial statements to determine the fair value of the business, while technical analysis assumes that a security’s price already reflects all publicly-available information and instead focuses on the statistical analysis of price movements. Technical analysis attempts to understand the market sentiment behind price trends by looking for patterns and trends rather than analyzing a security’s fundamental attributes.
Charles Dow released a series of editorials discussing technical analysis theory. His writings included two basic assumptions that have continued to form the framework for technical analysis trading.
- Markets are efficient with values representing factors that influence a security’s price, but
- Even random market price movements appear to move in identifiable patterns and trends that tend to repeat over time.
Today the field of technical analysis builds on Dow’s work. Professional analysts typically accept three general assumptions for the discipline:
1: The market discounts everything
Technical analysts believe that everything from a company’s fundamentals to broad market factors to market psychology are already priced into the stock. This point of view is congruent with the Efficient Markets Hypothesis (EMH) which assumes a similar conclusion about prices. The only thing remaining is the analysis of price movements, which technical analysts view as the product of supply and demand for a particular stock in the market.
2: Price moves in trends
Technical analysts expect that prices, even in random market movements, will exhibit trends regardless of the time frame being observed. In other words, a stock price is more likely to continue a past trend than move erratically. Most technical trading strategies are based on this assumption.
3: History tends to repeat itself
Technical analysts believe that history tends to repeat itself. The repetitive nature of price movements is often attributed to market psychology, which tends to be very predictable based on emotions like fear or excitement. Technical analysis uses chart patterns to analyze these emotions and subsequent market movements to understand trends. While many forms of technical analysis have been used for more than 100 years, they are still believed to be relevant because they illustrate patterns in price movements that often repeat themselves.
How Technical Analysis Is Used
Technical analysis attempts to forecast the price movement of virtually any tradable instrument that is generally subject to forces of supply and demand, including stocks, bonds, futures and currency pairs. In fact, some view technical analysis as simply the study of supply and demand forces as reflected in the market price movements of a security. Technical analysis most commonly applies to price changes, but some analysts track numbers other than just price, such as trading volume or open interest figures.
Across the industry there are hundreds of patterns and signals that have been developed by researchers to support technical analysis trading. Technical analysts have also developed numerous types of trading systems to help them forecast and trade on price movements. Some indicators are focused primarily on identifying the current market trend, including support and resistance areas, while others are focused on determining the strength of a trend and the likelihood of its continuation. Commonly used technical indicators and charting patterns include trendlines, channels, moving averages and momentum indicators.
In general, technical analysts look at the following broad types of indicators:
- Price trends
- Chart patterns
- Volume and momentum indicators
- Moving averages
- Support and resistance levels
The Difference Between Technical Analysis And Fundamental Analysis
Fundamental analysis and technical analysis, the major schools of thought when it comes to approaching the markets, are at opposite ends of the spectrum. Both methods are used for researching and forecasting future trends in stock prices, and like any investment strategy or philosophy, both have their advocates and adversaries.
Fundamental analysis is a method of evaluating securities by attempting to measure the intrinsic value of a stock. Fundamental analysts study everything from the overall economy and industry conditions to the financial condition and management of companies. Earnings, expenses, assets and liabilities are all important characteristics to fundamental analysts.
Technical analysis differs from fundamental analysis in that the stock’s price and volume are the only inputs. The core assumption is that all known fundamentals are factored into price; thus, there is no need to pay close attention to them. Technical analysts do not attempt to measure a security’s intrinsic value, but instead use stock charts to identify patterns and trends that suggest what a stock will do in the future.
Limitations Of Technical Analysis
Some analysts and academic researchers expect that the EMH demonstrates why they shouldn’t expect any actionable information to be contained in historical price and volume data. However, by the same reasoning, neither should business fundamentals provide any actionable information. These points of view are known as the weak form and semi-strong form of the EMH.
Another criticism of technical analysis is that history does not repeat itself exactly, so price pattern study is of dubious importance and can be ignored. Prices seem to be better modeled by assuming a random walk.
A third criticism of technical analysis is that it works in some cases but only because it constitutes a self-fulfilling prophesy. For example, many technical traders will place a stop-loss order below the 200-day moving average of a certain company. If a large number of traders have done so and the stock reaches this price, there will be a large number of sell orders, which will push the stock down, confirming the movement traders anticipated.
Then, other traders will see the price decrease and also sell their positions, reinforcing the strength of the trend. This short-term selling pressure can be considered self-fulfilling, but it will have little bearing on where the asset’s price will be weeks or months from now. In sum, if enough people use the same signals, they could cause the movement foretold by the signal, but over the long run this sole group of traders cannot drive price.
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