The ChoosaBroker Trading Academy

10.1. What is Technical Analysis?

Technical analysis is the study of past price and volume data to identify future trends in an asset’s price. Technical analysis is based on three critical assumptions:

  • Assumption 1: An underlying asset’s price reflects all that is known about the asset under consideration.
  • Assumption 2: Asset prices tend to move in broad directional trends.
  • Assumption 3: Once an asset establishes a price trend, it tends to continue until fresh evidence suggests a reversal in direction.
Let us review some of the most popular technical analysis tools in the following segment.

Dow Theory

Followers of the century old “Dow Theory” reckon that everything that is there to know about an underlying market is included in price, making the use of indicators redundant. The Dow Theory defines a trend as series of rising swing lows (uptrend) or falling swing highs (downtrend). Trend is nothing but the broad direction in an underlying asset. Prices don’t travel in straight lines, and retrace after a strong move. The position and direction of these retracements were used by Charles Dow, and subsequently, Robert Rhea, while defining a trend.

Within every trend, there are periods of retracement, which provide traders the opportunity to enter in the direction of the main market move. To locate a retracement, we switch to a lower time frame chart and first seek for a contra-trend move to unfold. In case of the major trend being up, this is confirmed by the formation of lower swing highs on the smaller time frame chart. Our task now as traders is to wait for this pullback to end. Traders can enter long at the break of the last pivot high on the lower time frame, which will also signal the resumption of the uptrend. In case of the dominant trend being down, the ideal place to short is the end of a contra-trend rally on the lower time-frame, signalled by the formation of a lower pivot low.

Chart Patterns

Price charts, and the patterns they produce, tend to invariably reiterate themselves. This has been at the core of technical trading for over a century. History repeats itself. So do the human emotions of fear and greed. And it is this predictable nature of human reactions that generate these predictable price patterns, offering us an edge in any market we trade.

Charts patterns can be classified as either reversal or continuation patterns. Reversal patterns signal a change in market trend. Head and shoulders, double top and double bottom are examples of reversal chart patterns. A continuation pattern confirms the continuation of the existing trend. Flags and pennants are the two most popular continuation patterns.

Candlestick Patterns

Candlestick patterns were first used by the Japanese to trade rice in the 17th century. In order to plot a candlestick chart, we need to have open, high, low and closing price for each time period under display. The filled portion of the candlestick is called “the real body.” The thin lines that extend above and below the real body represent the high and the low respectively, and are called “shadows” or “wicks.”

If an underlying asset’s price closes higher than its opening price, a green candlestick is drawn, with the bottom of the real body depicting the open and the top of the real body signifying the closing price. On the other hand, if price ends lower than open, a red candlestick is drawn, with the top of the real body representing the open, and the bottom indicating the closing price.

The most widely applied candlestick patterns include the doji, hammer, hanging man, engulfing, piercing lines and two black gapping.

Momentum Oscillators

A momentum oscillator reveals short term overbought and oversold conditions in a currency pair. Oscillators operate under the assumption that as momentum begins to change, the number of active buyers and sellers likely to trade at current market price decrease. As a result,

  • In a rising market, a shift in momentum suggests that price has reached an upper resistance area and is likely to reverse.
  • During a declining market, a change in momentum indicates that price is close to a support zone and could potentially reverse.

Stochastic and Relative Strength Index are the most popular technical trading oscillators. Buy when an oscillator is oversold and short when it becomes overbought – that’s the generally accepted market wisdom. This strategy works great during range bound markets, with both the Stochastic and the RSI beautifully forecasting market reversal points. Troubles begin when an underlying asset starts to trend. Trading the overbought-oversold signals during such phases can result in a string of false trades as the oscillators refuse to come out of the indicator extremities in to more neutral territory.

A rising tide lifts all boats. Just like its dangerous to fight the tide, riding against the trend – fashionably called “contrarian trading” – is fraught with enormous risks. The sole aim of any newcomer to financial trading is to first understand and locate trend, and then take trades in its direction. This can be achieved by waiting for a price correction within the dominant trend, and then initiating trades on the appearance of a divergence between price and momentum oscillators.

Fibonacci Retracements Levels

In his 1202 book “Liber Abaci,” Italian mathematician Leonardo “Fibonacci” Pisano first propounded the concept of Fibonacci Levels. Fibonacci discovered that in the sequence of numbers – 0, 1, 1, 2, 3, 5, 8, 13, 21, etc, each number is the sum of its prior two numbers. Another remarkable feature of this sequence is that each number is approximately 1.618 times greater than its predecessor. This common ratio existing between the numbers in the sequence forms the foundation of how Fibonacci Retracement Levels are used in financial trading. Traders horizontally plot the key Fibonacci retracement levels of 23.600%, 38.2%, 50.0% and 61.80% on a price chart to locate likely reversal areas. This helps market participants locate high probability long entry zones areas after a bull market pullback, and shorting areas after a bear market bounce.

Final Few Thoughts

Financial market forecasting strategies are either fundamental or technical. While fundamental analysis is the preferred tool for long term investors, it has very little value in short term trading. For such market participants, technical analysis has been shown to provide superior returns. Review our best online brokers for support in day trading.

Technical analysis is over 100 years old. Before the advent of modern computing technology, traders had to plot the price charts by hand. The scenario has completely changed now with the introduction of trading platforms that allow us to plot a thousand different types of technical indicators. However, technical analysis is ultimately the study of price and volume. And that’s all it takes to profit from the markets.

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