From Japanese rice traders in the 17th century, the concept of technical analysis has since then evolved, and is along with fundamental analysis the leading schools of thought when investors analyse the future direction of financial markets.
Where fundamental analysis is made by examining the key ratios of a business, technical analysis is based on historical data from charts to see where the market is heading. When making an in-depth analysis it therefore makes sense to have both methods complementing each other instead of choosing one over the other.
“We can clearly see that technical analysis is increasing in popularity.”
“We can clearly see that technical analysis is increasing in popularity. Some rely solely on technical analysis in their trading endeavours whereas others use it as a supplement to fundamental analysis. Some tend to misunderstand what it is about, but technical analysis is very simple in its core, and is all about leveraging data to strengthen one’s risk management in terms of when to enter and exit a trade.” says Kim Cramer Larsson, technical analyst at Saxo Group.
The danger of falling in love with a trade
The market is over-flooded with information and it is human behaviour to filter out the stories that we do not like and place greater confidence in the sources we like. Adding this to the common tendency that many investors tend to follow a few companies or indices very closely results in an investor being inclined to fall in love with his position.
“It is very easy to take greater and greater risk when holding a losing position. And unfortunately, this often makes us change our investment horizon when holding a losing position hoping it will bounce back tomorrow. And to avoid the negative feelings of having a losing position we often add to that position to bring down the average price and thereby the loss in percentage. These actions are driven by emotions and can be eliminated by using some of the tools available from technical analysis to set a proper stop-loss that is integral to an investor’s approach to risk management,” says Kim Cramer Larsson. He has been studying investor psychology for years and sees many people making this exact mistake.
The importance of trends
When using technical analysis, observing trends is an important discipline. In short, a trend can be described as the general direction of the market during a specified time period. Trends can be both bullish and bearish, and the length may vary between hours and months. Utilising trends can help investors piece together a full investment overview and give indications when to invest – and when not to.
5 technical analysis tools and how to use them:
Simple Moving Average
A simple moving average is a useful tool to analyse the trend of a security since it smooths out price movements and reduces ‘noise’. It is calculated by adding the closing price of a security for a distinct amount of time – usually 20, 50 or 200 days – and then dividing this total by that same number. A shorter amount of days will lead to more volatility. When using a simple moving average, you look for the time when the two moving averages cross which is usually referred to as either a ‘death cross’ or a ‘golden cross’. While these can be used to identify an emerging trend, they are not the strongest signals as the simple moving average is a lagging indicator.
The golden cross occurs when the 50-day simple moving average crosses above a rising 200-day moving average. This is considered a sign of a bullish market and a buying indicator. Here it is exemplified by the Tesla stock, where the golden cross occurred in the beginning of 2017 marking the starting point of a positive trend in the stock price.