By examining price action to determine which force is prevailing, technical analysis focuses directly on the bottom line: What is the price? Where has it been? Where is it going?
Technical analysis involves looking at patterns in price history to determine the higher probability of time and place to enter and exit a trade. As a result, technical analysis is one of the most widely used types of analysis.
How to use this guide
Who remembers when the fundamental analysis was considered the only real or proper way to make trading decisions? Back in 1970-1980, technical analysis was used by only a handful of traders, who were considered by the rest of the market community to be, at the very least, crazy. As difficult as it is to believe now, it wasn't very long ago when Wall Street and most of the major funds and financial institutions thought that technical analysis was some form of mystical hocus-pocus. Now, of course, just the opposite is true. Most experienced traders use some form of technical analysis to help them formulate their trading styles and strategies. Except for some small, isolated pockets in the academic community, the "purely" fundamental analyst is virtually extinct. What caused this dramatic shift in perspective?
Why Technical Analysis
We're sure it's no surprise to anyone that the answer to this question is quite simple: Money! The problem with making trading decisions from a strictly fundamental perspective is the inherent difficulty of making money consistently using this approach.
For those of you who may not be familiar with fundamental analysis, let us explain. Fundamental analysis attempts to take into consideration all the variables that could affect the relative balance or imbalance between the supply of and the possible demand for any stock, commodity, or financial instrument.
Using primarily mathematical models that weigh the significance of a variety of factors (interest rates, balance sheets, weather patterns, and numerous others), the analyst projects what the price should be at some point in the future. The problem with these models is that they rarely, if ever, factor in other traders as variables. People, expressing their beliefs and expectations about the future, make prices move—not models. The fact that a model makes a logical and reasonable projection based on all the relevant variables is not of much value if the traders who are responsible for most of the trading volume are not aware of the model or don't believe in it. In fact, many traders, especially those on the floors of the futures exchanges who can move prices vary dramatically in one direction or the other, usually don't have the slightest concept of the fundamental supply and demand factors that are supposed to affect prices.
Furthermore, at any given moment, much of their trading activity is prompted by a response to emotional factors that are completely outside the parameters of the fundamental model. In other words, the people who trade (and consequently move prices) don't always act in a rational manner.
The fundamental analyst could find that a prediction about where prices should be at some point in the future is correct. But in the meantime, price movement could be so volatile that it would be difficult, if not impossible, to stay in a trade to realize the objective.
What is Technical Analysis
Technical analysis has been around for as long as there have been organized markets in the form of exchanges. But the trading community didn't accept technical analysis as a viable tool for investing until the late 1970s or early 1980s.
Here's what the technical analyst knew that it took the mainstream market community generations to catch on to:
A finite number of traders participate in the markets on any given day, week, or month. Many of these traders do the same lands of things over and over in their attempt to make money. In other words, individuals develop behavior patterns, and a group of individuals, interacting with one another on a consistent basis, form collective behavior patterns. These behavior patterns are observable and quantifiable, and they repeat themselves with statistical reliability.
Technical analysis is a method that organizes this collective behavior into identifiable patterns that can give a clear indication of when there is a greater probability of one thing happening over another.
In a sense, technical analysis allows you to get into the mind of the market to anticipate what's likely to happen next, based on the kind of patterns the market generated at some previous moment. As a method for projecting future price movement, technical analysis has turned out to be superior to a purely fundamental approach. It keeps the trader focused on what the market is doing now in relation to what it has done in the past, instead of focusing on what the market should be doing based solely on what is logical and reasonable as determined by a mathematical model.
On the other hand, fundamental analysis creates what is called a "reality gap" between "what should be" and "what is." The reality gap makes it extremely difficult to make anything but very long-term predictions that can be difficult to exploit, even if they are correct. In contrast, technical analysis not only closes this reality gap but also makes available to the trader an unlimited number of possibilities to take advantage of. The technical approach opens many more possibilities because it identifies how the same repeatable behavior patterns occur in every time frame—moment-to-moment, daily, weekly, yearly, and every time span in between.
In other words, the technical analysis turns the market into an endless stream of opportunities to enrich oneself.
Limitations of Technical Analysis Limitations
If technical analysis works so well, why would more of the trading community shift their focus from technical analysis of the market to mental analysis of themselves, meaning their own individual trading psychology?
The reason is that you're dissatisfied with the difference between what you perceive as the unlimited potential to make money and what you end up with on the bottom line. That's the problem with technical analysis if you want to call it a problem. Once you learn to identify patterns and read the market, you find there are limitless opportunities to capitalize. But, as we're sure you already know, there can also be a huge gap between what you understand about the markets, and your ability to transform that knowledge into consistent profits or a steadily rising equity curve.
Think about the number of times you've looked at a chart and said to yourself, "Hmmm, it looks like the market is going up (or down, as the case may be)," and what you thought was going to happen happened. But you did nothing except watch the market move while you anguished over all the money you could have made. There is a significant difference between predicting that something will happen in the market (and thinking about all the money you could have made) and the reality of getting into and out.
There are no guarantees the market will move in your favor, just probabilities. You should spend more time and effort thinking about how best to handle things if the market turns against you and how to limit inherent losses rather than just fantasizing about how it will turn in your favor.
We call these differences, and others like it, a "psychological gap" that can make trading one of the most difficult endeavors you could choose to undertake and certainly one of the most mysterious to master.
The big question is: Can trading be mastered?
Online trading is a difficult game to master. Very few people become successful at it. However, it is possible for virtually anyone to master the essentials if they are willing to make the necessary effort.
Attaining the proper psychological mindset for winning trading requires rigorous self-examination and self-discipline. You must learn to cultivate good trading habits because they aren’t things that come naturally to most people.
This is exactly what CAPEX Academy is designed to give you—the insight and understanding you need about yourself and about trading and its nature.
The Basis of Technical Analysis
At the turn of the century, the Dow Theory laid the foundations for what was later to become modern technical analysis. Dow Theory was not presented as one complete amalgamation but pieced together from the writings of Charles Dow over several years. Of the many theorems put forth by Dow, three stand out:
- Price discounts everything: Technical analysis utilizes the information captured by the price to interpret what the market is saying with the purpose of forming a view of the future.
- Price movements are not random: One way of viewing the situation is that markets may witness extended periods of random fluctuation, interspersed with shorter periods of non-random behavior… The goal of the chart analyst is to identify those periods
- “What” is more important than “Why”: Technicians believe it is best to concentrate on what and never mind why. Why did the price go up? There were simply more buyers (demand) than sellers (supply). The value of any asset is only what someone is willing to pay for it. Who needs to know why?
How is the technical analysis used?
Unlike fundamental analysis, the technical analysis ignores speculation about what may be inﬂuencing supply and demand. Instead, it focuses purely on how (not why) prices move and what that movement suggests about future price behavior.
Of all the trading skills, you’ll need to understand technical analysis ﬁrst because it’s the basis for much of our risk control decisions, such as:
- Deﬁning what trades offer the lowest risk, highest potential yield entry, and exit points so that we can buy low and sell high (or vice versa in the case of short positions).
- Identifying price levels for stopping losses or taking partial proﬁts if the trade threatens to turn against us.
- Deciding position size and partial position entry or exit.
Technical Analysis occurs mostly on charts, which are pictures of trader behavior over a given period, regardless of what fundamentalists may speculate is the reason behind that behavior. The ﬁrst step in learning technical analysis is to read and understand the price charts.
Technical analysis can be as complex or as simple as you want it. The example below represents a simplified version of bullish situations.
Overall Trend: The first step is to identify the overall trend. This can be accomplished with trend lines, moving averages, or peak/trough analysis. For example, the trend is up if the price remains above its upward sloping trend line or a certain moving average. Similarly, the trend is up if higher troughs form on each pullback and higher highs form on each advance.
Support: Areas of congestion and previous lows below the current price mark the support levels. A break below support would be considered bearish and detrimental to the overall trend.
Resistance: Areas of congestion and previous highs above the current price mark the resistance levels. A break above resistance would be considered bullish and positive for the overall trend.
Momentum: Momentum is usually measured with an oscillator such as MACD. If MACD is above its 9-day EMA (exponential moving average) or positive, then momentum will be considered bullish or at least improving.
Buying/Selling Pressure: When technical indicators like Chaikin Money Flow is above zero, buying pressure is dominant. Selling pressure is dominant when it is below zero.
Relative Strength: Indicators like RSI (Relative Strength Index) help traders see which trading pairs are the strongest and which are the weakest on different time scales. The plot of this line over a period of time will tell us if the price is overbought or oversold.
The last step is to synthesize the above technical analysis to ascertain the following:
- Strength of the current trend.
- Maturity or stage of the current trend.
- The reward-to-risk ratio of a new position.
- Potential entry levels for a new long position.
Strengths of Technical Analysis
Here we review 5 strengths of technical analysis in helping traders to shape their trading strategies.
Focus on Price
If the objective is to predict the future price, then it makes sense to focus on price movements. Price movements usually precede fundamental developments. By focusing on price action, technicians are automatically focusing on the future. The market is thought of as a leading indicator and leads the economy by 6 to 9 months. To keep pace with the market, it makes sense to look directly at the price movements. Often, change is a subtle beast. Even though the market is prone to sudden unthinking reactions, hints usually develop before significant moves. A technician will refer to periods of accumulation as evidence of an impending advance and periods of distribution as evidence of an impending decline.
Supply, Demand, and Price Action
Many technicians use Japanese candlestick charts when analyzing the price action of a currency pair or stock. There is information to be gleaned from each bit of information. Separately, these will not be able to tell much. However, taken together, the open, high, low, and close reflect forces of supply and demand.
The length of the bodies and the wicks, in absolute terms and relative to each other, can tell us a great deal about supply and demand over the duration of a given candlestick.
The longer the wicks are relative to the body, the greater the indecision and the greater the back-and-forth struggle between buyers and sellers, and the more likely the current trend will cease or reverse.
- The shorter the wicks are relative to the body, the more decisive the move up or down, and the more likely that the move will continue in the same direction.
- A long higher close body with few or no shadows shows buyers outnumbered sellers and were in control during the entire period covered by the candle, steadily pushing the price higher. The longer the candle body, the greater the buying strength.
- A long lower close body with few or no shadows shows that sellers outnumbered sellers and were in control during the entire period covered by the candle, steadily pushing prices lower. The longer the candle body, the greater the selling strength.
- A small body relative to the wicks suggests the same indecisiveness to a lesser degree. If the body is red, the sellers were modestly stronger; if green, the opposite is true.
By looking at price action over an extended period, we can see the battle between supply and demand unfold. In its most basic form, higher prices reflect increased demand, and lower prices reflect increased supply.
Simple chart analysis can help identify support and resistance levels. These are usually marked by periods of congestion (trading range) where the prices move within a confined range for an extended period, telling us that the forces of supply and demand are deadlocked. When prices move out of the trading range, it signals that either supply or demand has started to get the upper hand. If prices move above the upper band of the trading range, then demand is winning. If prices move below the lower band, then supply is winning.
Support and resistance levels can be spotted using indicators such as moving averages, Bollinger Bands, Fibonacci retracements, pivot points, powerful Japanese candle patterns, or different western chart patterns like head and shoulders, double and triple tops, double and triple bottoms, and many more.
For example, the head and shoulders pattern is one of the most common reversal formations. It occurs after an uptrend and usually marks a major trend reversal when complete. Identification of neckline support and volume confirmation on the break can be the most critical factors. The support break indicates a new willingness to sell at lower prices. Lower prices combined with an increase in volume indicate an increase in supply. The combination can be lethal, and sometimes, there is not second chance to return to the support break. Measuring the expected length of the decline (measuring the distance from the neckline to the top of the head) after the breakout can be helpful, but do not count on it for your ultimate target.
Pictorial Price History
Even if you are a tried-and-true fundamental analyst, a price chart can offer plenty of valuable information. The price chart is an easy-to-read historical account of a pair's price movement over a period. Charts are much easier to read than a table of numbers.
On most charts, volume bars are displayed at the bottom. With this historical picture, it is easy to identify the following:
- Reactions prior to and after major events.
- Past and present volatility.
- Historical volume or trading levels.
- The relative strength of a stock versus the overall market.
Assist with Entry Point
Technical analysis can help with timing a proper entry point. Some analysts use fundamental analysis to decide what to buy and technical analysis to decide when to buy. It is no secret that timing can play a key role in performance. Technical analysis can help spot demand (support) and supply (resistance) levels as well as breakouts. Simply waiting for a breakout above resistance or buying near support levels can improve returns.
Technical analysts consider the market to be 80% psychological and 20% logical. Fundamental analysts consider the market to be 20% psychological and 80% logical. Psychological or logical may be open for debate, but there is no questioning the current price of a security. It is available for all to see, and nobody doubts its legitimacy. The price set by the market reflects the sum knowledge of all participants, and we are not dealing with lightweights here. These participants have considered (discounted) everything under the sun and settled on a price to buy or sell. These are the forces of supply and demand at work. By examining price action to determine which force is prevailing, technical analysis focuses directly on the bottom line: What is the price? Where has it been? Where is it going?
Even though there are some universal principles and rules that can be applied, it must be remembered that technical analysis is more of an art form than a science. As an art form, it is subject to interpretation. However, it is also flexible in its approach and each investor should use only that which suits his or her style. Developing a style takes time, effort, and dedication, but the rewards can be significant.
Trading can be challenging, which means it's important to do your homework beyond the above points. Some other key considerations include:
- Understanding the rationale and underlying logic behind the technical analysis.
- Backtesting trading strategies to see how they would have performed in the past.
- Practicing trading in a demo account before committing real capital.
- Being aware of the limitations of technical analysis to avoid costly failures and surprises.
- Being thoughtful and flexible about scalability and future requirements.
- Start small in the beginning and expand as you gain experience.
If technical analysis sounds like a hassle, try CAPEX Academy: the friendliest place designed to give you the insight and understanding you need about yourself and about trading and its nature.
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