What is technical analysis?February 20, 2021 2021-04-18 20:40
What is technical analysis?
Technical analysis is a method of analysing a financial market in the hope of predicting where the price will go next. It uses technical data to create patterns to help you predict the next move.
The primary data it uses are price, time and volume. These are plotted on charts, which is sometimes why you might hear technical analysis referred to as ‘charting’.
Successful traders understand that a market is based on how humans behave. It is their emotions that see the price rise and fall. As human emotions don’t change, you tend to see these emotions repeat themselves in the markets, which is where patterns arise.
This is why you see patterns in the markets and is why technical analysis is used to try and take advantage of them.
Technical analysis is one of several approaches to decide which direction you think a market will go. The most common types of analysis you’ll see include fundamental analysis, strategic, quantitative, sentiment, and technical analysis.
This is a great place to start to get an understanding about what technical analysis is and how you can use it in your trading.
Technical analysis basics
As a technical analyst and trader, you need to analyse the financial markets to try and predict where the price will go. You’ll use patterns that have shown themselves to be successful over time to make these predictions.
You’ll use historical data, normally plotted on a chart, to make future predictions. Due to the growth of this type of analysis there are thousands of different indicators and strategies you can use.
The idea is to find a pattern in the market. This should give you an indication of the price direction. If the pattern is accurate, a high percentage of those patterns will result in the price going in the predicted direction. This then allows you to trade that prediction and hopefully profit from it.
To start with, you’ll need to know the three core features of technical analysis. These are assumptions that we adhere to.
- The price discounts everything — This means that any and all factors that can affect the price of an instrument are already reflected in the price.
This means that factors like the following are already included in the price. You should not try to assume that they’ve not been accounted for yet.
- Macro and micro economic events
- Geopolitical threats (wars, general elections or natural disasters)
- Expectations of central bank and government actions
- All market participant emotions
- Prices tend to move in trends — Markets move in two phases; one is a stable phase where a market ranges between two levels and two is a more stable phase where the price either trends up or down. The basic rule of trading is to always go with the trend. It’s therefore hugely important that you understand what a trend is and how you can use it to your advantage.
- History repeats itself — As we’ve already highlighted, history repeats itself because markets are based on human behaviour. Humans have always had the same emotions and always will. They will get nervous, they will get scared, they will get excited, all which can be seen in the markets.
If we take a quick look at two scenarios and how the markets reacted. The stock market crash of 2008 and the 2020 market collapse due to the COVID-19 outbreak. These were two completely different scenarios, yet individuals still reacted the same way. Investors got scared and began selling their high risk holdings and buying low risk. This is why we saw stocks in both circumstances plummet, while gold (the safe haven) rallied.
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Technical analysis of financial markets
Technical analysis is not a new phenomenon. It is certainly more accessible now thanks to the internet and advanced technology but it can be traced back to the 17th century, where Joseph de la Vega introduced concepts that we still use today.
The great thing about technical analysis is that you can use it on any asset class. This includes the traditional financial markets like forex, stocks, bonds and commodities, but also on other markets like the classic car or housing market.
If you have access to prices over different periods of time, you can plot them on a chart to understand how it has moved.
The financial markets have been around for centuries and although we don’t have all that data, we do have decades worth that can be analysed. This is not only one price per day, but every price the market traded. This means that we can use technical analysis on different time frames to speculate on the price. You can analyse periods spanning only a few minutes, up to multiple years.
How does technical analysis work and why is it important?
Technical analysis works because the patterns that you recognise using this method of analysis are based on psychological behaviour of the market participants.
If you’ve invested in Apple stock and you see that you’re losing money, your natural erection would be that of nervousness and perhaps panic. You wouldn’t be alone in this, and this is what drives the market. That emotion will then drive a reaction, and while it isn’t exactly the same for everyone, if you average it out, you will find most react in that way, hence why the market moves.
Those emotions come from the price but also from the influences of price. Macroeconomic data, geopolitical risk and much more will affect the price because humans will react to their outcome.
If it is announced that all air travel is banned (similar to that of the COVID-19 impact), the price of oil will drop. Why? Because the investors will note that considerably less will get used, demand drops, therefore price reduces. Investors sell their holdings because they expect the price to fall, and it does (dramatically in the COVID-19 case).
As we’ve mentioned, it is not the news that moves the price, but the reactions of the investors and market participants.
For example, if the US and North Korea were to go to war, you would assume that this would have a negative impact on the financial markets. In fact, it is how the investors react to this news that will move the price of the market.
If for example, this war has been on the cards for a long time, and investors had been expecting it for a while, they will have already priced in the effects of the war in the market. And in fact, the start of the war, while negative in itself, will offer clarity to the market, rather than uncertainty.
Markets like certainty, it’s a positive development from uncertainty and this boosts investors confidence. Despite a negative thing happening, they know for sure that it will happen and can therefore plan against it. Not knowing, means that investors don’t know how to plan.
Technical analysis is great for beginners because it doesn’t require you to have a deep understanding of economics. As it uses data, it is a rule based approach, that beginners can easily put in place and follow easily. It provides structure to your trading and ensures that you build a consistent and reliable trading plan.
Technical analysis examples
Technical analysis continues to grow and grow. As it’s data based, mathematicians and theorists keep coming up with new indicators and new ways to look at the market in the hope of finding the perfect strategy.
It’s unlikely you’ll learn them all and frankly it’s unnecessary to learn them all. You should just know the ones that work for you.
As we’ve mentioned technical analysis is normally conducted on charts. And there are lot’s of them; bar charts, candlestick charts, line charts, Heiken Ashi charts, Renko charts, and tick charts, charts, charts, charts.
Other popular examples of technical analysis include price patterns. There are two different types of patterns; continuous and reversal. Continuous patterns are found when the market stalls and then continues in the same direction, while reversals are where the market changes direction completely.
Indicators are widely used when traders use technical analysis. There are thousands of different variations as more and more people devise news ones. The main inputs to these indicators are the prices open, close, low, and high, as well as the trading volume. They can be displayed either below or on top of the chart.
When you should use technical analysis
Technical analysis should be used across most of the major financial markets and asset classes. So, you can analyse forex, stock indices, and individual shares, and apply what you learn to commodity markets and more. You could actually use market analysis on anything that has a fluctuating price. Examples are UK house prices, or the value of a painting by David Hockney or Damien Hirst.
You should use technical analysis to help you plan your trade. Even if your view on direction has been made by another technique, using technical analysis can help plan your entry and exit.
It can be applied to practically any time frame of trading or investing — as long as there’s reliable price data over time and the markets are liquid. The term ‘liquid’ refers to assets that can be easily bought or sold. This makes it possible to use technical analysis as an approach to predict market prices.
For centuries, it’s been used for long-term investing over months and years and for short-term trading over days and weeks. In the modern era, with its automation and computers, the latest technical analysis methods are used in high-frequency trading on sub-second time intervals.
When you should not use technical analysis
The main circumstance where you shouldn’t use technical analysis is when the market is illiquid. This means that there aren’t very many buyers or sellers and fewer prices to plot against time.
One key difference of an illiquid market is the fact that you can negotiate on the price. Whereas in a liquid market there is simply no room, you either accept that price or you don’t buy.
Markets like penny stocks that have very low prices are susceptible to market manipulation and therefore it’s worth being wry when using technical analysis on those.
Technical analysis advantages
Technical analysis works. There are proven patterns that do repeat themselves over time and with accurate analysis and consistent implementation, you can use it to predict future price movements.
Below are some of the key advantages of using technical analysis.
- Proven patterns — Traders have proven that by finding the same patterns in the market, they can predict the future price movements. There are countless papers on these that show if you follow certain patterns, over time, you can trade the markets profitably. If they didn’t work, traders wouldn’t use it.
- Rule-based — A huge advantage (especially for beginners) is that it’s rule based. You can create a set of rules and procedures to follow which will ensure consistency in your trading. If created correctly, rules are black and white, therefore removing any discretion.
- Remove emotions — The fact that it is rule based means that you follow your strategy. This removes emotion that can hurt your performance. If you follow these rules correctly, there is no place for emotions. The question is – do the rules allow me to take this trade, yes or no? And you follow accordingly.
- Simple — It’s relatively simple and easy to get your head around, especially for beginners. Unlike fundamental analysis which requires a deep understanding of the overall economic picture. Technical analysis at its core is very simple.
- Multiple time frames — It allows you to look at the markets using different timeframes. This gives you a clearer picture of how the market is moving.
Technical analysis limitations
We’ve highlighted when you shouldn’t use technical analysis and those are also limitations of the analysis approach.
To reaffirm, technical analysis is not appropriate for:
- Illiquid markets
- Markets with only a small number of participants
On top of these limitations, there is one other major criticism of using technical analysis when analysing the financial markets. It is called the Efficient Markets Hypothesis (EMH) and essentially says that past prices cannot predict future ones. It is similar to the Random Walk Hypotheses, which states that price changes are random.
What do the technical analysts think of this? The following points are their main comebacks:
- EMH doesn’t consider the behavioural aspects of trading
- Emotions, and irrationality do influence financial markets
- History does repeat itself because human behaviours and emotions do not change over time. Excitement, fear, panic and hope are emotions that humans have always felt, and will continue to do so
The next stage in our technical analysis module takes a look at trading charts and what they are.