Key Takeaways
Technical analysis (TA) is a method that relies on price history and volume to forecast market trends.
TA can be done with simple support and resistance levels or with a combination of charting indicators like moving averages, RSI, MACD, and Bollinger Bands.
Trading signals can help us identify buying and selling opportunities, but TA indicators can also produce false signals, especially in lower time frames or low-liquidity markets.
It’s important to do risk management and cross-confirmation with other methods to reduce risks.
Introduction
Technical analysis (TA) is a charting method used to forecast the price movements of assets by analyzing historical price data and trading volumes. Unlike fundamental analysis (FA), which considers multiple factors around the price of an asset, TA is strictly focused on historical price action and chart patterns. Traders use TA to identify trends, support and resistance levels, and potential entry and exit points for trades.
When was TA created?
While primitive forms of technical analysis appeared in 17th-century Amsterdam and 18th-century Japan, the modern TA is often traced back to the work of Charles Dow.
A financial journalist and founder of The Wall Street Journal, Dow was among the first to observe that individual assets and markets often move in trends that could be segmented and analyzed. His work later gave birth to the Dow Theory, which encouraged further developments in technical analysis.
In the early stages, the rudimentary approach of technical analysis was based on hand-made sheets and manual calculations, but with the advance of technology and modern computing, TA became widespread and is now an important tool for many investors and traders.
How Does Technical Analysis Work?
TA operates on the premise that all known information is already reflected in an asset's price. So, by studying price patterns and trading volumes, traders can anticipate future price movements.
At its core, TA is the analysis of the market forces of supply and demand, which are a representation of the overall market sentiment. In other terms, the price of an asset is a reflection of the opposing selling and buying forces, and these forces are closely related to the emotions of traders and investors (essentially fear and greed).
Notably, TA is considered more reliable and effective in markets that operate under normal conditions, with high volume and liquidity. High-volume markets are less susceptible to price manipulation and abnormal external influences that could create false signals and render TA useless.
Common TA Indicators
Traders employ various technical indicators to analyze price movements and identify potential trading opportunities. Some of the most commonly used indicators include:
1. Moving averages (MAs)
Simple Moving Average (SMA): Calculates the average price over a specific period, smoothing out short-term fluctuations.
Exponential Moving Average (EMA): Gives more weight to recent prices, making it more responsive to new information.
Moving averages help identify the direction of the trend and potential support or resistance levels. For instance, a common strategy involves observing the crossover of short-term and long-term moving averages to signal potential buy or sell opportunities.
2. Relative Strength Index (RSI)
RSI is a momentum oscillator that measures the speed and change of price movements on a scale of 0 to 100. Traditionally, an RSI above 70 indicates overbought conditions, while an RSI below 30 suggests oversold conditions.
3. Bollinger Bands (BB)
The Bollinger Bands (BB) indicator consists of two lateral bands that flow around a moving average line. These bands are used to measure market volatility and identify potential overbought or oversold conditions.
4. Moving Average Convergence Divergence (MACD)
MACD is a trend-following momentum indicator that shows the relationship between two EMAs. It consists of the MACD line, signal line, and histogram, which can help identify potential buy or sell signals.
Trading Signals
While indicators are useful for identifying general trends, they can also be used to generate trading signals that suggest potential entry or exit points:
Overbought/oversold conditions: Indicators like the RSI can signal when an asset is overbought (potential sell signal) or oversold (potential buy signal).
Moving average crossovers: A bullish signal occurs when a short-term moving average crosses above a long-term moving average (golden cross), while a bearish signal occurs when it crosses below (death cross).
MACD signals: When the MACD line crosses above the signal line, it may indicate a bullish trend; crossing below may suggest a bearish trend.
It's important to note that the trading signals provided by technical analysis are not always accurate. There is a considerable amount of noise (false signals) produced by TA indicators, especially with short-term trading. To reduce losses, it’s important to use TA indicators in conjunction with other analysis methods and risk management strategies.
Criticism
TA is seen by many as a controversial and unreliable method and is often referred to as a “self-fulfilling prophecy,” referring to events that only happen because a large number of people assumed they would happen.
So, while TA is widely used, it has some limitations:
Self-fulfilling prophecy: Some critics argue that TA works because many traders use the same indicators, leading to predictable outcomes.
Subjectivity: Interpretation of charts and patterns can be subjective, leading to different conclusions among traders.
Market anomalies: TA may be less effective during periods of high volatility or when markets are influenced by unforeseen events.
Despite these criticisms, many traders find TA valuable, especially when combined with other forms of analysis. TA supporters argue that each chartist has a particular way of analyzing the charts and using the indicators available. This would imply that it’s virtually impossible for a large number of traders to use the same particular strategy.
Technical Analysis vs. Fundamental Analysis
While TA focuses on historical price data and patterns, fundamental analysis (FA) evaluates an asset's intrinsic value based on financial statements, economic indicators, and other qualitative factors.
Technical analysis: Best suited for short-term trading strategies, helping identify optimal entry and exit points.
Fundamental analysis: More appropriate for long-term investment decisions, assessing the overall health and potential of an asset.
Many investors use a combination of both approaches to make informed decisions, leveraging the strengths of each method.
Closing Thoughts
Besides the criticisms and the long-standing controversial debate about which method is better, many prefer to use a combination of both TA and FA. While FA usually relates to long-term investment strategies, TA may provide insightful information into short-term market conditions, which may be useful for all kinds of traders and investors.
Further Reading
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