Technical analysis refers to the method of analyzing markets based on their historical price movements. It is in contrast to fundamental analysis which deals with macro and micro economical influences. So, a fundamental analyst would look at the morning unemployment news and how it may move the markets. However, a technician would consider how prices have moved during past months, days, or hours, and based on that information alone would decide the most likely future price movement.
It is not a new science although it proliferated with the development of computers. Japanese had used it for centuries for analyzing the rice market by developing charting system called Candlesticks. And in the 1930’s Ralph Elliot developed his own technical analysis currently referred to Elliot Wave Principles. Volumes of the book have been written on both analysis and in many financial circles are followed to this day.
Naturally, present day technical analysis has grown in complexity, but it can roughly be divided in two separate areas: one that is easily programmable, and one that is, just like Candlestick or Elliot Waves previously mentioned, mostly dependent on visual recognition.
Visual recognition analysis consists of charting. Here the most important factor is the drawing of trend lines by connecting with the straight line most significant highs or lows (significant meaning one that sticks out and is easily noticeable in the chart – the high of the last bar would not be significant if current bar would have a higher high). Actually the lines drown offer sort of supply and demand lines, points at where buyers are rushing in (lines connecting the lows) and points where sellers are flooding the market (lines connecting the highs). In trends often these lines will form a channel of a price movement serving as an indicator of when to buy and sell.
Equally important is noting the points of resistance and support. When price can not close above certain level, stated level is referred to as the resistance. Support points are just the opposite as they indicate points where market stops on the way down. These points often reflect psychological barriers to trend continuation. They increase in significance longer they are present and with each unsuccessful attempt to cross them. But when the market brakes though them, it creates a strong signal that the further trend is ready to develop.
Further study of the charts will reveal different formations, such as Flag or Triangle formations. Usually they can be found in areas of congestion, or side way movements. They are not necessarily indicative of the change in trend, but rather that the trend will continue once the pattern is broken.
Programmable technical analysis basically consists of previously established and well defined formulas . One of the most often used is the Moving Average indicator. It is an average of the past closing prices. When the price crosses it and closes on the “other” side of it, it can serve as an indicator of the ending of the trend or the starting of the new one.
Also, very popular is the Bollinger Band which is derived by adding and subtracting two standard deviations of closing prices from their moving average. Importance is given to the area where prices move above or below the bands. Other standardized indicators with programmable formulas behind them include Stochastic, Oscillators, Relative Strength Index (RSI), and others. These often serve as secondary indicators, and can pin point areas of excessive buying or selling which usually results in contra moves. Also, closely watched by many traders is the volume representing the level of executed transactions, which when looked with other indicators can reveal the strength of underlying price move.
However, technical analysis does not need to end there. After studying the markets, you can actually create your very own technical indicator with the use of programmable platforms such as TradeStation, MetaTrader or others.
The benefit of all this technical analysis is that it takes most of subjectivity out of the trade planning and reserves the trading decision to statistically proven method. In other words, with technical trading you are trying to be like a casino, trying to put the odds of winning in your favor.
Extremely important to note here is that none of this systems work hundred percent of the time and each should be tailored to one’s personality. Crucially important is the discipline, proper money management and a risk allocation.
If you think this is all too technical to even be considered, please be advised that majority of the most successful traders base their trading signals on technical analysis. So, if people that make millions think they can not live without them, why should you?
Check here for the previous Technical Analysis post.
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