Lesson 3 - Introduction to Technical Analysis
Introduction to Technical Analysis
What is technical analysis?
Technical analysis is the financial methodology for forecasting where an asset’s price will go based on the idea that ‘history repeats itself.’ This means that traders who use technical analysis will analyze historical price fluctuations in order to predict future trading conditions. Technical analysts believe that price movements that have happened in the past will happen again in the future. You can apply technical analysis to any financial instrument that has historical data: securities, currencies, commodities, futures, and so on.
In technical analysis, charting is an indispensable element. Technical analysts will use charts to map out trends, identify lucrative trading opportunities, and visualize historical data. Technical analysis is subjective despite being a very commonly used concept. It is not so much about prediction, as it is about probability.
How does technical analysis work?
Unlike fundamental analysis, technical analysis does not seek to measure an asset’s underlying value. Instead, it uses technical indicators and charts to capture patterns that could then be used as a base to enter and exit trades. The core difference between fundamental and technical analysis is that technical analysts focus solely on historical data, volume, and price. In addition to this, technical analysis focuses on the future.
Technical analysts have three underlying objectives:
• To profit from the market by observing statistics and price patterns
• To understand when to enter or exit a market
• Not to allow emotions to influence their actions
Traders who utilize technical analysis believe that price patterns actually repeat themselves in the future. Therefore, they will often attempt to take advantage of this perception and follow past trades. Technical analysts depend on the principle that an asset’s price already reflects all the crucial information regarding its price fluctuations. Technical analysis boils down to the analysis of supply and demand in a specific asset, to see where the price trend is headed.
Technical analysts follow three core assumptions:
1. Price fluctuates in trends
2. History tends to repeat itself
3. The market discounts everything – this means that the impact of macroeconomic conditions is automatically factored into the price.
Since technical analysis is focused on trader’s emotions, it can only work in auction markets. In auction markets, buyers and sellers unite to a single price, determined by the lowest ask price and the highest bid price. Therefore, technical analysts must identify the trend and the support/resistance using pricing charts and timeframes. Markets tend to move in a zigzag fashion, which results in prices remaining in two states. One is range; this is when prices move sideways. The second is the trend, which is when prices either zigzag in an uptrend or a downtrend.
What tools do technical analysts use?
Technical analysts depend on studying price action, chart patterns, and technical indicators. For this, technical analysts use statistical tools called technical indicators. Technical indicators are heuristic or pattern-based signals generated through mathematical calculations based on price, volume, and open interest of a financial instrument. They are widely customizable and help interpret data. Technical indicators are split into two categories: Leading indicators, which attempt to predict price by using a shorter period in their calculations, and lagging indicators, which give a signal after the trend or reversal has already started and are primarily used to determine a trend.
Trend Indicators
Trend indicators measure the strength and direction of a trend based on a certain price used as a baseline.
• Moving Averages: Used to identify current trends and reversals and set support and resistance levels.
• Moving Average Convergence (MACD): Used to capture changes in direction, momentum, duration, and strength in a trend.
• Parabolic SAR: Used to reveal possible reversals in the price direction of the market. It is also known as a “stop and reverse system.” Out of all three, it is the only leading indicator.
Momentum Indicators
Momentum indicators help identify the speed of price/volume movement by comparing prices/volume over time. They are calculated by comparing the current closing price to the previous closing prices. A discrepancy between price and momentum can indicate a future change in prices.
• Stochastic Oscillator: Used to forecast price turning points by comparing the price to the closing range. The stochastic oscillator always moves between 0 and 100. If it indicates a reading above 80, then it’s considered an overbought zone, and a reading below 20 an oversold zone.
• Commodity Channel Index (CCI): Used to capture price trend strength, price reversals, and price extremes.
• Relative Strength Index (RSI): Used to measure a stock’s trading strength. The indicator measures the magnitude of current price change in stock to establish whether it is undervalued or overvalued. RSI is considered overbought when above 70 and oversold when below 30.
Volatility Indicators
Volatility indicators are used to measure the rate of price movement regardless of the direction, based on the lows and highs in historical prices. Volatility indicators offer insight into the range of purchasing and selling in a given market.
• Bollinger bands: Used to measure the highs and lows of the price compared to previous trades.
• Average True Range: the average of true ranges over a specified period. ATR measures volatility, taking into account any gaps in the price movement.
• Standard deviation: Measures expected risk and establishes the importance of certain price movements.
Volume Indicators
Volume indicators measure the strength or a trend and confirm its trading direction based on raw volume. Strongest trends tend to occur when volume increases and can help lead to large movements in prices.
• Chaikin Oscillator: Measures and monitors money flowing in and out of the market to identify changes in cycles.
• On-Balance-Volume (OBV): Measures the level of distribution or accumulation by comparing price movements.
• Volume Rate of Change: Highlights rise in volume that usually occurs at market highs and lows.
The history of technical analysis
Technical analysis data goes as far back as the 17th century, where Japanese rice merchants used it. Homma Munehisa, a rice merchant from Sakata, Japan, developed the popular charting tool called the candlestick technique. Since computers were not available to execute statistical analysis, technical analysis was predominantly based on charts. The concept was further innovated in the 19th century by the famous financial inventor, Charles Dow. The inventor created the ‘Dow Theory’ that became a basis and inspiration for modern technical analysis techniques.
Other pioneers include: Ralph Nelson Elliot - developed the theory Elliott Waves, William Delbert Gann, the method Gann angles, and Richard Wyckoff - created the tool called the composite operator. All of them have used technical analysis as their basis. Why do we still use the same techniques as we did almost 400 years ago? Well, the human pursuit of capitalizing on fear and greed has not changed. It remained consistent enough for us to be able to use it, centuries later.
What is Candlestick?
A candlestick signifies the trading range for a given period. It is a type of chart representing the high, low, open, and closing prices of a particular security at a certain period. The candlestick’s body is the wide part, and it tells traders whether the closing price is lower or higher than the opening price. The candlestick’s color will change according to the day’s highs or lows; for example, green candlesticks mean that there is significant buying; therefore, the market is bullish. A red candlestick will indicate the opposite – the asset is being sold; therefore, we have a bearish market.
You can have infinite time frames that can be employed in charts. They can be based on minutes or on an hourly, daily, weekly, and monthly basis. Traders must pay significant attention to shapes, sizes, colors, and the trend of candlesticks.