In this blog we often discuss technical analysis and its peculiarities, providing you with strategies and explaining how the indicators work. Yet, not all traders, especially those who have just started exploring the financial markets, understand what technical analysis is and why it is important to use it. Yet, even those who consider themselves experts might find this article useful.
What is technical analysis?
Technical analysis is an attempt to understand and predict future price movements based on the past performance of the price action. As any prediction, technical analysis is not 100% accurate and can provide false signals. Nonetheless, this method aims to reveal the most likely outcome based on the current conditions.
Stocks, currencies, cryptocurrencies, commodities, indices and ETFs can all be subject to technical analysis. In other words, principles of technical analysis are universal and can be applied to any instrument/asset. More than that, all assets can be analyzed using the same tools (indicators).
How does it work?
Technical analysis works for assets where the price is influenced by the law of supply and demand and doesn’t work for securities where prices are regulated otherwise (say, by political decrees).
Moreover, there are several assumptions that have to be fulfilled in order for technical analysis instruments to work properly.
High liquidity. The underlying asset has to be traded in sufficient volumes. Low-liquidity assets are easier to manipulate and harder to trade in general. Factors associated with low-liquidity trading make it unsuitable for technical analysis.
No artificial price changes. A stock split, being an artificial price change, does not affect the intrinsic value of the company at hand, yet it dramatically changes the stock price. Suchlike events cannot be addressed by technical analysis.
No extreme news. Certain events — like a terror attack and the demise of a company’s CEO — cannot be predicted by the means of technical analysis.
Basic principles
Price discount everything. Technical analysts believe that the price action fully reflects all publicly available information. In other words, all past events and announcements about the future ones have already been reflected by the asset price. The price, therefore, reflects the fair value of the underlying asset. This information is then used to predict the future.
Price movements are not totally random. There are periods when prices trend and periods of non-trending prices. Technical analysts believe that it is possible to identify both short and long-term trends with the help of indicators.
‘What’ is more important than ‘Why’. What is the price and ‘What will it be?’ is usually the only questions technicians ask themselves. While fundamental analysis is concerned with the reason behind price fluctuations, technicians are not. To technicians, prices go up when demand surpasses supply, and that’s it.
How to use technical analysis in practice?
A lot of technical analysis specialists apply top-down approach, first evaluating broad indices, then separate industries, and only then moving to individual stocks. No matter what asset and on what timeframe you analyze, the steps you take will be approximately the same. First, you might want to identify the trend (e.g. Moving Average or Alligator). Then you might want to identify support and resistance levels, upper and lower boundaries than the price action cannot leave on a certain time frame (here a horizontal line can be of great help). Next you might want to identify the momentum (e.g. MACD or any other oscillator) and optimal entry/exit points. As a final step, you might want to compile all of the above-mentioned data and use it to make a prediction.
Conclusion
Experts in the field of technical analysis consider the market to be explained by 80% psychology and only 20% logic. It is, therefore, important to learn to interpret signals you receive from the market but don’t be surprised that it takes time to learn and master technical analysis.
