Written by Brenda Nakalema

Introduction to Technical Analysis

Technical analysis refers to the use of complex statistical trends gathered from analyzing trading activity, such as price movement and …

Technical analysis refers to the use of complex statistical trends gathered from analyzing trading activity, such as price movement and volume, to determine the viability of an investment. Unlike Fundamental analysis, that seems to focus more on intrinsic factors to determine the value of an investment; technical analysis bases its findings on hard cold truth; what the numbers actually say about the prospects of a particular investment to help investors make informed technical analysis decisions.

What is meant by Technical Analysis

Technical Analysis tools provide tools that can be employed to understand the ways supply and demand for a security will influence changes in price, volume, and implied volatility. With Technical analysis, it is believed that past trading activity and price changes of a security are possibly valuable indicators of the security’s future price movements, especially when combined with appropriate investing or trading rules.

In most cases, it is used to generate short-term trading signals from different charting tools; however, it can also be applied to improve the evaluation of a security’s strengths or weaknesses relative to the Marco market or its sectors. With this information, analysts are able to their overall estimate of an investment.

Technical Analysis was the brainchild of Charles Dow, who was the proponent of the Dow Theory in the late 1800s. Afterwards, several other brilliant researchers contributed to the theory, most notably; William P. Hamilton, Robert Rhea, Edson Gould, and John Magee. In the present day, technical analysis has evolved to include hundreds of patterns and signals developed through years of research.

Technical analysis is not applied solely by technical analysis traders. Fundamental analysts apply fundamental analysis to determine where they should put their money in the market and utilize technical analysis to select suitable, low-risk buy entry price levels.

How to do Technical Analysis

Most analysts don’t use technical analysis alone but in combination with other forms of research to make near accurate analyses of a security. Retail traders might opt to make decisions based entirely on price chart movements of a security and similar statistics, but practising equity analysts almost never limit their research to technical analysis or fundamental analysis.

Technical analysis can be used to analyze any security, as long as it has an accurate record of past historical trading data. This might include stocks, futures, commodities, fixed-income, currencies, and cryptocurrencies.

Technical analysis is an attempt to predict the price movements of virtually any tradable instrument that can be influenced by the forces of both demand and supply, including stocks, bonds, futures, and currency pairs. In certain instances, some have chocked technical analysis merely as the study of supply and demand as reflected in the price movements of a security on the stock market.

Although technical analysis primarily applies to price changes, some analysts track numbers other than just price, for example, trading volume or open interest figures.

Technical Analysis indicators

The industry is loaded with hundreds of patterns and signals that different researchers have developed in an effort to support the growth of technical analysis trading. Technical analysts have also developed tons of trading systems to aid in the forecast and trade of price movements.

A few indicators are applied to forecasting based on specific factors such as the current market trend, including support and resistance areas. In contrast, others are more fine-tuned to factors like determining the strength of a trend and the possibility of its continuation. A few commonly used technical analysis indicators and charting patterns include trendlines, channels, moving averages, and momentum indicators.

Generally, technical analysts focus on a few major types of indicators;

  • Price trends
  • Chart patterns
  • Volume and momentum indicators
  • Oscillators
  • Moving averages
  • Support and resistance levels

Price

Technical analysts hold the belief that future price action can be reliably predicted by analyzing past price trends in the market.

Chart Patterns

Technical analysis traders analyze price charts with the intention of predicting price movements. There are two primary variables for technical analysis; time frames and the particular technical analysis indicators that a trader chooses to utilize. Charts typically feature technical analysis time frames that are grouped from one-minute, monthly or even yearly time spans. Technical analysts frequently examine the following time frames;

  • 5- minute chart
  • 15- minute chart
  • Hourly chart
  • 4-hour chart
  • Daily chart

The time frame typically selected by a trader is determined by his preferred trading style. For instance, intra-day traders (traders who open and close trading positions within a single day) typically prefer analyzing short time frame charts like 5-minute or 15-minute charts. On the other hand, long-term traders who hold their positions for more extended periods of time are more inclined to analyze markets using 4 hours, daily and maybe even weekly charts.

For Intra-day traders, price movements that occur within the smaller time spans of 5- 15 minutes could be very significant because they are looking to profit from the fluctuations during one trading day. Interestingly, that same price movement monitored on a daily or weekly chart might not catch the attention of a long term trader.

Candlesticks

This is one of the most commonly used methods of illustrating price movement on a chart. A candlestick is created from the price action during a single time period for any given time frame. Each candlestick on an hourly chart, for instance, show the price fluctuations within an hour, while each candlestick on a 4-hour chart shows the fluctuations during every 4-hour time period.

Candlesticks are drawn in the following way: The highest point of a candlestick indicates the highest price a security can be traded at during that period of time, and the lowest point of the candlestick is an indication of the lowest price during that time.

Candlestick patterns- Dojis

The most widely used candlestick patterns are those that can be formed by either a single candlestick or by a succession of two or three candlesticks and are the most widely used technical analysis indicator for identifying potential market reversals or trend change.

For instance, Doji candlesticks indicate indecision in the market that might be a signal for an impending trend change or market reversal. The longer the upper and or lower trails- the part of the candlestick that indicates a low-to-high range for that time period in questions- the greater the indication of indecision in the market and potential reversal. The most important characteristic of the Doji candlestick is the fact that the opening and closing prices are the same, making the candlestick body a flatline.

There are several variations of the Doji candlesticks;

Long-legged Doji; This is the typical Doji where price extensions are roughly equal in each direction, opening and closing in the middle of the price range for the time period. If a dog like this appears following an extended uptrend, it is commonly interpreted as a signal toward a possible market reversal, a change in the trend towards the opposite direction. The candlestick appearance gives us a clear visual indication that there is market indecision.

Dragonfly Doji; If this Doji appears after a prolonged downtrend, it signals a possible upcoming reversal to the upside. Further analysis of the price fluctuations indicated by the dragonfly Doji would explain its logical interpretation. The dragonfly sellers push the price substantially lower (the long lower tail), but by the end of the period, the price seems to recover at the highest point. It is an indication of a rejection of the extended push to the downside.

Gravestone Doji; As is indicated by the name, this Doji is clearly bad news for the buyers. The opposite of the dragonfly, the Gravestone Doji, indicates a strong rejection of an attempt to push market prices higher, thereby suggesting there might be a potential downside reversal.

Four price Doji; with this Doji indicates the extreme indecision in the market. Here the market opens, closes, and in-between conducts all buying and selling at the exact same price throughout a particular time period. In this case, the market shows that it has no inclination to go anywhere.

Other technical analysis indicators

Moving Averages; Technical analysis traders have other tools in their arsenal other than the candlestick formations that they can use to draw thousands upon thousands of technical analysis indicators to assist in making trading decisions. Traders widely use moving averages, and in fact, this might be one of the most widely used technical analysis indicators. A simple moving average strategy goes along the lines of something like “Buy as long as price remains above the 50- period exponential moving average (EMA); Sell as long as price remains below the 50 EMA. “

Moving average crossovers are also used as a trading strategy to buy when the 10-period moving average crosses above the 50-period moving average.

In general, the higher the moving average, the more significant price movement in relation to it is considered. For instance, price crossing above or below a 100- or 200- period moving average is mostly considered much more important than price moving above or below a 50- period moving average.

Pivots and Fibonacci numbers; Daily pivot point indicators which are typically used to identify several support and resistance levels in addition to the pivot point, are utilized by many traders to identify price levels for entering or closing trades. Pivot point levels mark important support or resistance levels where trading is contained within a certain range. Suppose trading rises or falls through the daily pivot and all the associated support or resistance levels. In that case, this could be interpreted as a “breakout” trading that will eventually shift market prices substantially in the direction of the breakout.

Fibonacci Retracements; Another common technical analysis tool is Fibonacci retracements. Fibonacci was a 12th-century mathematician that developed a series of ratios popularly used by technical analysis traders. Fibonacci ratios are most widely used to pinpoint trading opportunities with both trade entry and profit targets arising during sustained trends.

Just like with pivot point levels, there are many freely available technical analysis indicators that can automatically calculate and then load Fibonacci levels onto a chart. The primary Fibonacci ratios are 0.24,0.38, 0.62, and 0.76, which are often expressed in percentages. Fibonacci retracements are often applied after a security has been in a sustained uptrend or downtrend; there would then be corrective retracement in the opposite direction before the price would resume the overall long-term trend. These retracements identify good, low-risk trade entry points during such a retracement.

For instance, supposing stock XY has gained slowly from $10 to $50. Then the stock prices started to fall a bit. Most investors would look for a good entry-level to buy shares during the price retracement. Fibonacci numbers make the assumption that likely price retracements will extend a distance equal to 24%, 38%, 62%, or 76% of the uptrend from $10 to $50. For instance, if an investor was planning to buy the stock after roughly 38% retracement in price, they might place the order to buy at around the $31 price level. (The move from $10 to $50= $40; 38% of $40 is $15; $50- $15= $35)

Fibonacci extensions; These are extension levels placed at prices that represent 126%, 138%, 162% and 176% of the original uptrend move, typically calculated from the low level of the retracement. Using the previous example, if a 38% retracement of the original uptrend from $10 to $50 turns out to be the retracement low, then from that price ($35), an investor would find the first Fibonacci extension level and potential “take profit” target by adding back 126% of the original $40 uptrend.

Fibonacci extension level of 126%= $35 + ($50 x 1.26) = $98 (price target)

Momentum indicators; Moving averages and other technical analysis indicators are typically focused on predicting the most likely market direction, up or down. The other set of technical analysis indicators are not utilized to determine market direction but rather market strength. These indicators include popular tools such as the Stochastic Oscillator, the Relative Strength Index (RSI), the Moving Average Convergence- Divergence (MACD) indicator and the Average Directional Movement Index (ADX).

Measuring the strength of price movement allows momentum indicators to help investors determine whether the current price movement more likely represents insignificant, range-bound trading or an actual significant trend. Momentum indicators can also serve as early warning signals that a trend might be coming to an end.

Underlying assumptions of Technical analysis

Of the methods typically used to analyze securities and inform investment decisions, two main methods stand out as the most primarily used; fundamental analysis and technical analysis.

Fundamental analysis uses both macro and micro-economic factors such as the state of the economy, industry conditions, the company’s management team, and company sales over a certain period to determine the viability of an investment. On the other hand, technical analysis involves a focus on analyzing the effect forces of demand and supply might have on a company’s prospects by looking into past historical data of a company using various statistical tools. Technical analysis attempts to understand the market’s sentiments at the back of price trends by analyzing patterns and trends rather than looking into the security itself.

According to Charles Dow, the inventor of the Dow Theory, there are two basic assumptions that form the underlying framework for technical analysis;

  1. Markets are efficient with identifiable values representing factors that influence the price of a security, but,
  2. Identifiable patterns and trends can be recognized in even the most seemingly random market price movements and that these trends often tend to repeat themselves over time.

In the present time, Charles’ theories have been adjusted and added to by other professional analysts, and finally concluded on these three general assumptions;

  1. The market discounts everything:

Technical analysts hold the belief that everything from a company’s fundamentals to broader market psychology is already priced into the stock. This belief is similar to the Efficient Markets Hypothesis (EMH), which reaches a similar conclusion about prices. Technical analysts include the analysis of price movements that they believe to be influenced by the forces of demand and supply for a particular security in the market.

  1. Prices move in trends:

Technical analysts expect that prices move in familiar trends regardless of the time frame being observed, even in random market movements, meaning that a stock price is more likely to continue a past trend than move erratically.

  1. History tends to repeat itself:

Technical analysts hold the belief that the repetitive nature of price movements can be attributed to market psychology, which tends to mirror general market emotions like fear or excitement. Technical analysis analyses emotions and subsequent market movements using chart patterns to understand trends. Although many forms of technical analysis have been applied for over 100 years, their relevancy is undeniable because they capture price movements that often repeat themselves.

Limitations of Technical analysis

A few analysts and academic researchers assert that EMH provides enough evidence why they shouldn’t expect any tangible actionable information to be contained in historical price and volume data. However, they’d essentially be saying that business fundamentals don’t provide any useful information by the exact same reasoning.

Another criticism held against technical analysis is that history does not exactly repeat itself as the theory asserts, therefore making price pattern study seem more like educated guesswork and can therefore be ignored.

Technical analysis is also criticized on the basis that its success in certain cases is the result of the findings being a self-fulfilling prophecy. For instance, many technical analysis traders will place a stop-loss order below the 200-day moving average of a certain company. In case a large number of traders have followed in suit, and the stock hits this price, there will understandbly be a large number of sell orders, which will instead push the stock down, confirming the ‘predictions’ traders have put forth.

After that, other traders will see the price decrease and choose to sell their positions, reinforcing the strength of the trend. The short-term selling pressure brought on by this situation can be regarded as self-fulfilling.

Technical analysis isn’t perfect 100% of the time; savvy investors often closely watch their chosen indicators for signs that might be misleading their decision-making. However, when handled well, technical analysis can improve a trader’s level of profitability.