In this post we will see basics of technical analysis and beginners guide for technical analysis, with its framework, other technical techniques and technical analysis tools.
Technical analysis means the study of past price action and using it for forecasting future price movements. In short the study of past market data in form of charts, indicators and oscillators to try to measure and predict, what will happen in future? Fundamental analysis involves analyzing a company in order to estimate its value. Technical analysis takes different attitude; it doesn’t care about the “value” of a company. Technical analysis is only concerned in the price movements in the market and their study using candlestick formations, chart price patterns, and indicators, etc.
The Dow Theory is based on the collective writings of Charles Dow, is used as the framework for modern technical analysis.
Technical analysis framework contains three basic beliefs:
Market action discounts everything: All known information related to the stock is reflected in the current price of the stock. This also includes fundamental factors. As soon as new information comes to investors then it will reflected in price with movements. For examples, in forex market, factors such as economic data and risk sentiment are already merged in the current exchange rate and rate moves as soon as new information comes to the market.
Prices move in trends: In technical analysis prices tend to move in visible trends with a tendency to stay in the trend. The trend is considered to be intact until the trend line is broken. After a trend has been established, the future price movement is more likely to be in the same direction as the trend than to be against it. This is where the old adage “the trend is your friend” comes from, meaning you should trade in the same direction as the trend.
History repeats itself: Technical analysis is the study of what has happened to the price in the past with the expectation that history tends to repeat itself. Many of the charts patterns in technical analysis have been used for more than 100 years, they are still believed to be relevant because they demonstrate patterns in price movements that often repeat themselves. The repetitive nature of price movements is credited to market psychology and human nature. For examples, in currency market, previous price patterns have a high probability of occurring again and again.
Other techniques includes, such as Elliott theory which is introduced by Ralph Nelson Elliott and Gann theory which designed by William Delbert Gann, also comprise the commonly-used techniques in technical analysis of financial markets. We will see these techniques in details in upcoming posts.
There are a variety of different classes of technical analysis tools and indicators available to use with the price charts. These classes can be grouped as follows:
Trend lines, Support & Resistance levels and Fibonacci Studies are used to predict where and how a price is likely to move and to identify potential price reversal points.
Trend Following Momentum Indicators means “follow the trend”. They are useful in helping to confirm the overall direction of price movement. These indicators are considered “lagging indicators” as they lag behind the current price movement but they keep you on the right side of the trend. Although they can be late in signaling buy and sell opportunities. Examples of trending indicators include Moving Averages or MACD.
Momentum Oscillators measure price momentum and oscillate up and down between set limits over a center line. These indicators are typically “leading indicators”, that is they may give insight into where the price may go in the future. Examples of momentum indicators are RSI and Stochastic.
Volatility Indicators measure the degree of instability in price movement over a specified timeframe. High volatility means the price is unstable dramatically, low volatility means the price is stable and remaining relatively constant. Examples of volatility indicators are Bollinger Bands (which compare a market’s current price to its moving average) and Chaikin Volatility (which compares price to its high-low price range). Volatility indicators are best used in combination with other indicators for e.g. trend or oscillators to confirm the direction of the price movement.
Practical trading tips for better use of technical analysis:
- Before using any indicators, it is important to determine the major trend. Which indicators to use and their understanding varies depending on trend direction , For example, if the market is trading sideways then Stochastics or RSI are useful in identifying overbought or oversold conditions.
- Set indicator parameters and chart interval that’s suit your trading style, strategy and risk. Use longer periods if you are long term buy and hold or swing trader. Use shorter periods for day trading.
- Don’t depend on signals from one technical indicator or signals from a combination of indicators of the same group. If a technical indicator gives a buy or sell signal, look for confirmation of the signal from the indicators in other groups before acting.
This is The Technical Analysis beginners Guide and it will provide you an introduction to how technical analysis can be interpreted and used to timely trades. In upcoming posts, we will continue our technical trading journey with more information and examples so stay connected.