What is technical analysis?
Technical analysis is a way to look for ways to make money by studying how the prices of financial assets change over time.
The advantages of technical analysis have been extensively explored, but it is also necessary to consider the criticisms of this concept at this time in order to fully comprehend its consequences.
Scientists, especially those who believe in the “efficient market hypothesis,” often use the well-known “dart-throwing monkey” experiment to compare technical analysis to pure guesswork.
In the short-term investment horizon, however, a paper by Neely and Weller reveals that technical analysis may be preferable to fundamental data analysis. The momentum effect, according to Y. Zhu and G. Zhou, might be a potentially beneficial technical strategy based on historical price patterns. The effectiveness of the analysis might be greatly increased with the help of technical tools, according to research of over 2,000 Chinese stocks . Another piece of research on the Russian stock market reveals that technical indicators-based trading systems may beat a traditional “buy-and-hold” approach.
The validity of technical analysis is based on the idea that all market participants’ combined actions—buying and selling—accurately represent all relevant information relative to a traded security and hence continuously assign a fair market value to the security.
Technical analysis and crowd psychology
Prices in the financial markets fluctuate due to the daily interactions of millions of people and institutions in international financial markets. Participants in the financial market buy and sell things, which changes the prices of financial instruments and causes prices to go up and down.
Because people have consistent behavioral patterns and generally make trading decisions based on comparable emotions, technical analysis is quite effective.
Most individuals have heard phrases like “greed is good” or “shares are bought on expectations rather than reality.” This suggests that human psychology and general thinking habits play a significant role in financial market movements. Whether we’re talking about a Chinese speculator from 200 years ago, a Wall Street pit trader from 80 years ago, or a modern-day “Joe Bloggs Trader,” the human components, such as emotions and instincts, are nearly the same. For millennia, greed, fear, uncertainty, and the willingness to take risks have shaped human behavior, including, of course, how people have moved their money around the world’s markets. We will be able to read and handle any price chart, on any market, at any moment in the future if we learn to interpret the buyer and seller interaction from the charts.
The principle of self-fulfilling prophecy is another significant reason why technical analysis is so powerful. Because millions of people follow technical analysis concepts and make judgments based on them, they may check that technical indicators and other concepts function simply by looking at how widely they are used. Technical terms like historical highs and lows, all-time highs and lows, psychologically important price levels, and moving averages are frequently used in the financial media.
When we look at price structures and chart studies in this book, you’ll quickly find that technical trading is much more than it appears on the surface. We’ll have a better grasp of how to put ourselves in other traders’ shoes and interpret financial market players’ thought processes so that we can benefit from technical analysis through independent strategic thinking.
The majority of traders just do rudimentary technical analysis.
The majority of the literature does not normally go into detail about the underlying mechanisms. The opponents of technical analysis would be correct in their criticisms here because such a method is ineffective and trading cannot be limited to surface-level thinking. The purpose of this book is to look at technical analysis in a fresh and more effective light.
Past Price as an Indicator of Future Performance
Technical traders think that present or historical market price activity is the most accurate predictor of future price action.
Technical analysis is utilized by more than only technical traders. Many fundamental traders employ fundamental analysis to assess whether to purchase into a market, and then utilize technical analysis to identify solid, low-risk entry points for buying.
Charting on Different Time Frames
Technical traders examine price charts in an effort to forecast future price movement. The trader’s choice of technical indicators and the time frames they look at are the two most important parts of technical analysis.
On charts, the time ranges for technical analysis range from one minute to monthly or even yearly intervals. Popular time intervals frequently examined by technical analysts include:
- 5-minute chart
- 15-minute chart
- Hourly chart
- 4-hour chart
- Daily chart
The time range a trader chooses to analyze is often dictated by his or her own trading style. Intraday traders, or traders who open and exit positions within a single trading day, like to analyze price movement on shorter time frame charts, such as the 5-minute or 15-minute charts. Long-term traders who hold positions overnight and for a long time are more likely to use hourly, 4-hour, daily, or even weekly charts to analyze the market.
For an intra-day trader seeking to profit from price swings occurring throughout a single trading day, price fluctuations that occur inside a 15-minute time frame may be quite significant. If you want to trade over a long period of time, the same price movement seen on a daily or weekly chart may not be very interesting or helpful.
This is easily demonstrated by observing the same price behavior on multiple time frame charts. The accompanying daily chart for silver depicts the price fluctuating within the same range of approximately $16 to $18.50 for the previous several months. Given that the price is close to the range’s low point, a long-term investor in silver may be persuaded to purchase the metal.
On the other hand, the same price movement examined on an hourly chart (below) reveals a continuous fall that has recently increased significantly. On the basis of the price action on the hourly chart, a silver trader engaged exclusively in intraday trading would likely avoid purchasing the precious metal.
Candlesticks are the most popular method for displaying price movement on a chart. A candlestick is generated from the price activity over a single period of time for any time frame. Each candlestick on an hourly chart depicts the price movement for one hour, while each candlestick on a 4-hour chart depicts the price movement for each 4-hour period.
The following is how candlesticks are “drawn” or formed: The highest point of a candlestick reflects the highest price at which a security traded during a given time period, while the lowest point indicates the lowest price during the same time period. The “body” of a candlestick (the corresponding red or blue “blocks” or thicker regions of each candlestick as depicted in the preceding charts) reflects the opening and closing prices for the time period. If the body of the candlestick is blue, it means that the closing price was higher than the opening price. On the other hand, if the body of the candlestick is red, it means that the opening price was higher than the closing price.
Candlestick color choices are arbitrary. Others use green and red, or blue and yellow. Regardless of the color picked, it is simple to tell whether the price closed higher or lower at the end of a specified time period. The analyst receives more visual clues and patterns when utilizing candlestick charts for technical analysis than when using a regular bar chart.
Patterns of Candlesticks – Dojis
Candlestick patterns, which are created by a single candlestick or a succession of two or three candlesticks, are among the most popular technical indicators for identifying future market reversals or trend changes.
For instance, Doji candlesticks, for instance, signify hesitation in a market, which may be an indication of an oncoming trend reversal or market reversal. The unique attribute of a doji candlestick is that the beginning and closing prices are identical, resulting in a flat candlestick body. The longer the higher and/or lower “shadows” or “tails” on a doji candlestick – the portion that represents the low-to-high range for the time period – the stronger the indication of market hesitation and possible reversal.
As depicted in the image below, doji candlesticks come in a variety of styles, each with their own unique name.
The usual doji is a long-legged doji, in which the price extends roughly equally in both directions and opens and closes in the middle of the price range for the time period. The appearance of the candlestick provides a visual indication of market uncertainty. When a market has been going up or down for a long time and then this kind of doji appears, it is often seen as a sign of a possible market reversal or change in the direction of the trend.
When the dragonfly doji appears after an extended downturn, a possible upward reversal is imminent. Examining the price movement signaled by the dragonfly doji clarifies its logical explanation. The dragonfly depicts sellers driving the market much lower (the long lower tail), yet the price recovers to close at its maximum level. Essentially, the candlestick represents a rejection of the prolonged decline.
The name of the gravestone doji implies that it represents terrible news for buyers. The gravestone doji, the inverse of the dragonfly formation, signifies a severe rejection of an attempt to push market prices upward, suggesting a potential reversal to the downside.
The unusual four-price doji is a sign of indecision because the market opens, closes, and trades at the same price throughout the time period. This shows that the market is not likely to move in any particular direction.
There are dozens of distinct candlestick forms and variations on patterns. Probably the most comprehensive resource for detecting and employing candlestick patterns is Thomas Bulkowski’s pattern website, which describes each pattern in detail and offers historical data on how often each pattern has historically served as a solid trading signal. It’s obviously useful to understand what a candlestick pattern suggests, but it’s even more useful to know whether that indicator has been right 80% of the time.
Technical Indicators – Moving Averages
In addition to studying the shapes of candlesticks, technical traders can also use a huge number of technical indicators to help them decide what to do when trading.
Moving averages are most likely the most popular technical indicator. Multiple moving averages are utilized by numerous trading methods. Buy as long as the price continues above the 50-period exponential moving average (EMA); sell as long as the price remains below the 50-period EMA.
Moving average crossovers are an additional commonly used technical indicator. A possible trading strategy would be to purchase when the 10-period moving average crosses over the 50-period moving average.
The greater the quantity of a moving average, the greater the significance of a price change relative to it. For instance, the crossing of a price above or below a 100-or 200-period moving average is typically regarded as significantly more significant than a price crossing above or below a 5-period moving average.
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Technical Indicators – Pivots and Fibonacci Numbers
Fibonacci levels are a well-known method for technical analysis. Fibonacci was a mathematician from the 12th century who established a series of ratios that are widely used by technical traders. During protracted trends, Fibonacci ratios or levels are typically employed to identify trading opportunities as well as trade entry and profit targets.
0.24, 0.38, 0.62, and 0.76 are the basic Fibonacci ratios. These are sometimes stated as percentages, such as 23%, 38%, etc. Note that Fibonacci ratios go well with other Fibonacci ratios: 24% is the opposite or remainder of 76%, and 38% is the opposite or remainder of 62%.
Like pivot point levels, Fibonacci levels can be plotted on a chart automatically by a number of free technical indicators.
Fibonacci retracements are the most common application of the Fibonacci indicator. After a security has been in a continuous uptrend or downtrend for some time, there is sometimes a corrective retracement in the opposite direction prior to the price resuming its long-term trend. During a retracement, Fibonacci retracements are utilized to discover favorable, low-risk trade entry positions.
For instance, assume that the price of stock “A” has steadily risen from $10 to $40. The stock price then begins to decline slightly. During such a price pullback, many investors will seek a favorable entry point to purchase shares.
According to Fibonacci numbers, probable price retraces will span a distance equal to 24 percent, 38 percent, 62 percent, or 76 percent of the $10 to $40 rise. Investors monitor these levels for signs that the market is regaining support and that prices will resume their ascent. For example, if you wanted to buy the stock after a 38 percent price retracement, you could place a buy order near the $31 price level. (The increase from $10 to $40 is $30; 38% of $30 is $9; $40 minus $9 equals $31).
Continuing with the preceding scenario, you have now purchased the stock at $31 and are attempting to estimate a profit target selling price. For this purpose, you can refer to Fibonacci extensions, which show by how much the price may rise when the broader uptrend continues. The Fibonacci extension levels, calculated from the retracement’s low, correspond to prices that are 126 percent, 138 percent, 162 percent, and 176 percent of the initial upward advance. Consequently, if a 38 percent retracement of the first move from $10 to $40 turns out to be the retracement low, the first Fibonacci extension level and potential “take profit” target is found by adding 126 percent of the original $30 advance upward to this price ($31). Calculation proceeds as follows:
126 percent Fibonacci extension level = $31 + ($30 x 1.26) = $68-giving you a target price of $68.
Again, you are never required to perform any of these calculations. Simply insert a Fibonacci indicator into your charting software, and it will display all of the Fibonacci levels.
Even if you don’t employ pivot and Fibonacci levels in your own trading method, you should always track these levels. Because so many traders use pivot and Fibonacci levels to decide whether to buy or sell, there is likely to be a lot of trading activity around these price points, which can help you predict how prices are likely to move in the future.
Technical Indicators – Momentum Indicators
The primary purpose of moving averages and the majority of other technical indicators is to determine the expected market direction, either up or down.
However, there is a second class of technical indicators whose primary aim is not to determine market direction so much as market strength. Popular tools like the Stochastic Oscillator, the Relative Strength Index (RSI), the Moving Average Convergence-Divergence (MACD) indicator, and the Average Directional Movement Index (ADX) are among these indicators (ADX).
By assessing the magnitude of price movement, momentum indicators assist investors in determining whether the current price movement is indicative of a relatively minor, range-bound trade or an actual, major trend. As momentum indicators quantify the strength of a trend, they can serve as early warning signals when a trend is about to reverse. For instance, if a security has been trading in a strong, consistent uptrend for several months but one or more momentum indicators indicate that the trend is gradually losing strength, it may be time to consider taking profits.
The USD/SGD 4-hour chart demonstrates the usefulness of momentum indicators. The MACD indicator is displayed in a pane beneath the main chart window. The steep increase in the MACD beginning on June 14 shows that the corresponding price increase is a strong, trending rise and not merely a brief corrective. On the 16th, when price begins to retrace significantly downward, the MACD shows weaker price action, indicating that the downward price movement lacks significant power. Immediately thereafter, a robust rise resumes. In this case, the MACD would have reassured a buyer of the market that (A) the move up in price was a big one and (B) the uptrend was likely to continue after the small drop on the 16th.
As momentum indicators often indicate only strong or weak price movement and not trend direction, they are frequently paired with other technical analysis indicators as part of a trading strategy.
Technical Analysis – Conclusion
Remember that there is no ideal technical indicator. None of them consistently transmit signals that are 100 percent accurate.
The most astute traders are constantly on the lookout for indications that the signals from their chosen indicators may be false. Well-executed technical analysis can unquestionably increase your earnings as a trader. However, it may be more beneficial to your trading success if you devote more time and energy to considering how to respond if the market swings against you rather than simply daydreaming about how you’ll spend your millions.