What is technical analysis? What is technical analysis? What is technical analysis?

What is technical analysis?

Trading Strategies

Saxo Group

Technical analysis is a concept that many financial traders live by, utilising historical data to frame today’s trading conditions and future price moves. Traders that lean on technical analysis to build a picture of a potential trade will use indicators overlaid onto charts to ascertain potential entry and exit points. 

But no technical indicator is 100% foolproof. Trading signals aren’t accurate every minute of every day. However, many traders like to use technical indicators to identify patterns in the financial markets – many of which are replicated on a regular basis. It is these patterns that technical analysis traders use to forecast future price movements. 

How can technical analysis be applied? 

It’s possible to use technical analysis to research the most likely price moves of any security listed, providing it has historical trading data. This brings all kinds of instruments into play, including equities, forex (short for Forex Trading), commodities, futures and many other securities that are influenced by the conventional market forces of supply and demand. 

Nevertheless, the recurring patterns that technical indicators pick up are most commonly found in the most liquid markets, including forex and commodities. With unrivalled trading volumes in forex, it’s little wonder why most day traders focus solely on foreign currencies. 

With all kinds of technical analysis, traders use price charts to accurately anticipate future price moves. Timeframes of selected charts can be as regular as every minute or as sporadic as yearly, although many day traders that rely on technical indicators will use anything from five-minute to daily timeframes to work with. 

How technical analysis differs from fundamental analysis 

The number-one difference between technical and fundamental analysis is that the latter focuses solely on the ‘true value’ of an asset. Technical analysis looks beyond the external ‘noise’ beyond the markets and encourages traders to rely exclusively on the data. 

Technical analysis is also best used for those who trade in short-term timeframes. When we say short term, we really mean it. It could be just a few minutes or hours, rather than the days, months or even years involved with most trades underpinned by fundamental analysis. 

With fundamental analysis, most traders that use this approach look to find assets that are either undervalued or overpriced, placing trades in the hope that the price realigns to its true value over time. Meanwhile, technical analysis is best served by day traders that open and close multiple positions on an asset on the same day, taking advantage of recurring patterns in the market. 

While technical analysis looks exclusively at price movements and market psychology, fundamental analysis weighs up external information including the broader economic outlook of a relevant industry, competitor performance and other industry trends. 

In summary, technical analysis adopts a backward-looking approach to trading, believing that the past informs the future. Meanwhile, fundamental analysis takes a more balanced approach, looking ahead at the fiscal outlook, while taking recent industry news, announcements and analysis into consideration. 

Understanding trading candlesticks 

Candlestick charts are the most common type of chart used in technical analysis. Candlesticks are the linear assets used to denote the price movement of an instrument within a set timeframe. For example, when using an hourly chart, every candlestick displayed demonstrates the price action in the market for every hour. Similarly, one-minute charts will display candlesticks showing the price action in the market every 60 seconds. 

Candlesticks are ‘formed’ on a chart based on the price action. The top of a candlestick is used to denote the highest price an asset was traded during the selected timeframe. The lowest point of a candlestick denotes the lowest price an asset was traded during the same period. 

Each candlestick has a ‘body’. This is the thick part that’s either green (bullish) or red (bearish). The body is designed to replicate the opening and closing price of an asset over the selected timeframe. Green is generally the uniform colour for candlesticks that display a positive price move for an asset, while red is the uniform colour for candlesticks showing a decline in an asset’s value over a set period. However, the colour choice is an arbitrary decision. Depending on your choice of trading software, it may be that the candlesticks are white and black instead, or even blue and yellow. Either way, trading candlesticks are one of the quickest ways to understand whether a price closed higher or lower at the end of a selected timeframe. 

Some retail traders believe that candlesticks tell the bigger picture of an asset than a basic line or bar chart. That’s because a candlestick shows the highest and lowest price of an asset during a set timeframe to showcase its recent volatility. 

The most popular technical analysis indicators 

If you’re just starting out in financial trading and you’d like to learn more about technical analysis, read on as we explore some of the common technical indicators that retail traders use to interpret trends. 

Support and resistance levels 

Support and resistance are two of the most important price points for any trader to find. They indicate a price where buyers deem the price to be ‘value’ and a price where sellers deem the price to be ‘value’. 

Support is typically the start of an asset’s upward momentum, while resistance is generally the start of an asset’s downward momentum. Some day traders simply look to trade when an asset inches close to either the support or resistance price and act accordingly. 

Trend momentum 

If you are a trader that likes to follow market trends, you’ll want a technical indicator that enables you to measure the strength of a trend. There are a few popular indicators for momentum. Rate of Change (ROC) is a useful one which details how much one asset’s price has changed in a set timeframe. Welles Wilder, one of the pioneers of technical analysis in the 20th century, devised the Relative Strength Index (RSI) as a momentum indicator. It compares the current price change to other recent price changes for an asset. The higher the reading, the faster and bigger the change in price – and therefore the more sustained market momentum. 

There’s also the Moving Average Convergence Divergence (MACD) indicator that’s equally popular today for momentum. When a MACD indicator moves into positive territory, it is a green light for traders to buy an asset as the price’s moving average is greater than older ones. Similarly, when it moves negative, it’s a green light for traders to sell (short) an asset. 

Simple moving averages (SMAs) 

An SMA is the most basic version of a moving average and is a starting point for novice traders before graduating to a MACD indicator. An SMA adds up the closing prices of an asset over a set period and divides it by the number of minutes, hours, days or months you want. 

Let’s say you want to calculate the SMA of an asset over a 20-day period. You would add up the closing price each day divide the final sum by 20. You then have the average closing price for the last 20 days. By plotting this each day over time, the simple average will move with the price and can be used, for example, to eliminate some of the noise of day-to-day movements and better show the underlying trend. 

Average Directional Index (ADX) 

ADX is yet another trading indicator devised by Welles Wilder. ADX is an average of expanding price range values. It is used to measure the general strength of a price trend. Wilder said that when the ADX was above 25 an asset is experiencing a strong trend. When it is below 25 the trend is not strong enough to support. When it is below 20, the indicator believes there is no trend at all, suggesting market indecision. 

The advantages of technical analysis 

  • Ideal for traders looking for consistent patterns or entry criteria
    Technical analysis favours retail traders that want to take a methodical approach to their entry and exit points in the markets. Technical indicators can be used to provide consistency to traders’ trading strategies, in an ‘if X, do Y’ manner. In doing so, this prevents overtrading, which many novice traders fall into the trap of when experiencing the markets for the first time. 
  • Use historical data to back test strategies 
    Most trading platforms will have historical data on your chosen assets going back several years, if not decades. This is a huge advantage for those looking to develop their own trading strategies and angles. You can test your approach risk-free by delving back into the data archives to learn whether your methodology would have been profitable in years gone by. 
  • Compatible with any market or asset 
    Technical analysis can be undertaken on any asset or market. It’s an inclusive trading method to get your teeth stuck into. Once you’re familiar with the indicators, you can pinpoint trading angles and opportunities within any market, regardless of asset value or market depth. 

The drawbacks of technical analysis 

  • Mastering technical analysis is not an overnight process 
    There is a distinct learning curve to technical analysis. It can take several months or years to familiarise yourself with technical indicators and act on these insights. It’s a skill for retail traders to be able to decide which historical data is most relevant in forecasting future price moves. 
  • Some trading indicators are more reliable than others 
    It’s true that some trading indicators are more accurate than others in predicting future price moves. Some indicators work best within certain chart timeframes or patterns, and it takes time to understand which ones they are. 
  • Focus on supply and demand does not provide the complete picture
    At its core, technical analysis is a methodology focused solely on supply and demand. It doesn’t take into consideration the broader picture surrounding an asset and its wider marketplace. Technical indicators do not factor in fundamental analysis like news stories, press releases and analyst reports that can also have a bearing on an asset’s true market value. 

Technical analysis in summary 

If you are completely new to technical analysis but you want to start thinking analytically about your financial trading, there are several questions you can ask yourself when reviewing a market and related trading charts. Given that technical analysis is largely focused on price and trends, is the asset you’re interested in trending upwards and how close is it to the support and resistance lines? Is the asset trending downwards, upwards or sideways in the short term? 

Although technical analysis can help to give us a credible insight into the probable trajectory of an asset’s value, it is no guarantee. If you want to build the best possible picture of an asset, it’s best to undertake a blend of technical and fundamental analysis to ensure you see both sides of every story. 

Hopefully, this guide has explained how technical and fundamental analyses differ, and how the former can help those looking to scalp or flip assets in quick succession. 

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