Technical Analysis – What You Need to Know
Technical analysis is used by traders to predict the direction a market price is going to take. This makes it an extremely important concept in trading and investing. It is one of the methods that every trader should know about even if they don’t plan on using it.
There are many different types of traders and trading styles. Many traders define their trading style by the opportunities they can find. This is where technical analysis comes in. It is one of those methods that helps traders find trading opportunities and gain an edge.
This type of analysis can be a useful tool for any trader out there. Therefore, knowing how it works and developing trading strategies around it can be beneficial in many ways. In this article, we’ll talk about what technical analysis is, its basis, and the pros and cons associated with it.
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Technical analysis is a trading concept that is used to find trading opportunities. These opportunities are identified by looking at trend charts. These charts are gathered from trading activity. This trading activity includes factors such as price movements and volume.
Performing this type of analysis also helps one understand the emotions of the market. What this means is that the changes in the market are also guided by human psychology.
Further reading: 10 Online Trading Tips for beginners in 2021
The idea of technical analysis and its tools focus only on the ways supply and demand affect changes in price, volume, and volatility. Oftentimes, it is a strategy that is used to create short-term trading signals from different charting tools. However, it can also help determine the strength or weakness of a trade relative to the market. This can then help analysts and traders improve their overall market assumptions.
Overall, technical analysis can be used on any type of financial instrument that has historical trading data. Subsequently, this could include anything from stocks to currencies to bonds. One area where technical analysis is commonly used is the forex market where traders focus on short-term price movements.
First introduced in the 1800s by Charles Dow, technical analysis has grown significantly. It now includes hundreds of chart patterns and signals developed by analysts. Let’s have a brief look at the basis of technical analysis.
Trading requires skill to make the right guesses. For this reason, traders rely on available information to try and make an educated guess on the future of price movements. Then, based on those factors, they weigh their risks against potential rewards in their chosen asset.
Dow theory forms the basis of technical analysis. The rules of Dow theory guide traders in important market aspects, including:
- Types of trends
- The impact of current events on the market
- The phases of price movements
Key Assumptions Associated with Technical Analysis
Below are a few primary assumptions that technical analysis is based on:
- Historic price data can be helpful in predicting future movements. Technical analysts believe that they can predict the future based on historic data.
- Market prices move in trends. In Dow theory, there are three primary trend timeframes: primary movement, second reaction, and minor movement. Trades are made by taking these trends into account.
- History repeats itself. Analysts believe that past price trends repeat themselves in the future, too. Therefore, they look at previous price movements to decide when to open and close their future trades.
Types of Analysis: Technical and Fundamental
There are two main ways that traders analyze the markets:
- Technical analysis
- Fundamental analysis
While both methods are for researching and predicting future trends, there is a big difference between the two concepts. Both concepts essentially lie at opposite ends from each other.
Primarily, fundamental analysis focuses on the various internal and external factors of a trade. Fundamental analysts study everything related to economy and financial factors. This could include factors such as economic data, market price action, liabilities, assets, and earnings.
On the other hand, technical analysis largely focuses only on examining previous price movements to find trading opportunities. The main assumption is that every other factor is represented inside the price of trade anyway and so.
Often, traders use a mixture of technical and fundamental analysis. For example, many traders use fundamental analysis to find underpriced markets. After that, they use technical analysis to plan their enter and exit positions.
Advantages of Technical Analysis
1. Psychology
Technical analysis helps investors and traders understand the human psychology that affects the market. This provides them with a clear view of what they are doing and what they should do going forward.
2. Trend Analysis
One of the most prominent advantages of technical analysis is the way it helps traders predict the future of the market. There are usually three trends in the market:
- Up trend
- Down trend
- Sideways or ranging market
All these trends become easy to predict with the help of technical analysis.
3. Stop Loss and Target
The technical analysis clearly defines the Stop Loss and Target for a particular position. This helps traders decide whether they can endure the risk associated with a trade.
4. Early Signals
One huge benefit of technical analysis is that it provides an early signal before the reversal of a trend. This helps investors and traders make a decision based on those signals.
For example, Price-Volume Analysis can be used to analyze and observe the activities of market movers. By observing trends in volume along with price movements, traders are able to assess possible changes in a stock’s price.
5. Entry and Exit Points
Timing is the name of the game in trading. The right time to exit or enter a trade is crucial. Technical analysis helps investors and traders determine the right time to enter or exit.
Candlestick Patterns, Elliot wave theory, Dow theory, and Chart Patterns, are all part of technical analysis. These are important indicators that help traders make good entry and exit decisions.
Potential Drawbacks of Technical Analysis
Technical analysis relies only on the past to predict what may happen in the future. But just because something has happened before does not mean it will happen again. This attaches a few potential drawbacks to the technical analysis approach. Because not everything is pre-determined to happen in the future just because there is a prior trend relating to it.
Moreover, there are many external price drivers that a purely technical trader might overlook. This could include factors such as employment data – a factor that a fundamental analyst would pay more attention to.
What are the Uses of Technical Analysis?
As mentioned before, the technical analysis predicts future price movements of almost any tradable instrument with a history. This includes any instrument that changes with fluctuations in supply and demand, such as:
- Stocks
- Bonds
- Currency pairs
- Futures
- Cryptocurrencies
- Options etc.
Across each of these financial instruments, there are numerous methods of technical analysis. Market experts create these methods to support technical analysis trading. Plus, technical analysts themselves create many different trading systems that help them make the best predictions.
Key Takeaways
Technical analysis provides traders with a useful set of tools and concepts. These tools can then help to carry out careful trading actions.
You will come across many traders who are successful without technical analysis. And many who are successful with it.
At the end of the day, whether you should adopt technical analysis or not depends on your trading approach. There will never be a 100 percent guarantee that using one technique would lead you to profits.
Whichever strategy you choose to follow, there will be a learning curve. And you have to make sure you constantly learn from it to be able to generate profits. Follow your risk appetite and knowledge, and choose what is best for you.
In any case, making the right financial decision comes down to gaining the right knowledge from the right resources. This is where my blog can help. In it, you can find extensive trading resources. You can use that information in conjunction with my book Trading for Success to make the most of your trading journey.
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