If you’re new to trading then you’ve probably wondered what all those strange charts are that traders stare at constantly?
Well the study of those price charts is called is Technical Analysis, and this article will give you an overview of the discipline.
By explaining what is technical analysis and how it can help, it will prepare you for further articles that go more in-depth into some of the strategies I personally use.
The two forms of analysis
There are two main branches for studying financial markets. Technical analysis and fundamental analysis.
Technical analysis is the study of price chart patterns on all tradeable markets; the goal is to determine the future direction of prices.
Fundamental analysis, on the other hand, is the study of the reasons why price should move.
Fundamentals include aspects of the broad economy (interest rates, inflation, debt etc). Or in the case of individual stocks, a company’s earnings potential and financial performance.
Fundamental analysis is a long-term forecasting method, technical analysis, can be used in the long, short and very short-term.
Technical analysis is a visual art form
Markets can be studied technically on multiple timeframes, from 1-min charts (used by scalpers) to weekly, monthly and even yearly charts for long-term investing decisions.
Popular techniques include trendlines, support resistance, momentum indicator analysis, traditional chart patterns, Japanese candlesticks, Elliot wave, Gann angles, Dow theory and more.
Technicians will draw lines connecting price points on charts using trendlines or calculate moving averages on x number of prices data points.
They will measure momentum in a price move.
Or, look for long-term topping or bottoming formations, such as double tops, V bottoms or rounded bottoms.
The first chartists, including pioneers such as Charles Dow, W.D Gann and Ralph Nelson Elliot developed charting techniques that were all drawn by hand.
Advanced computing has led to a whole new range of techniques that have changed the discipline considerably from the days of the old-timers.
Prices move in trends
The core concept is that prices move in trends, on multiple timeframes and are therefore not random.
If prices do in fact move in trends, it means there’s a good chance any market participant can profit from a given price move.
All technical tools are used to identifying low risk, high probability entry points into the market.
Technical analysis can also be used to identify when a trend has become unstable or when it actually ends.
The most common way this is done is through the study of trendlines.
History repeats itself
Price charts are a visual representation of mass-market psychology.
And as the greed and fear in humans never change, the same price patterns are observed time and time again.
This happens through a boom and bust cycle constantly repeating.
Prices initially move slowly, as a few early market participants get involved.
Momentum then increases and a more noticeable market move takes place.
Eventually, the market becomes euphoric, going ever higher until the trend is no longer sustainable.
There is no one left to buy, and prices collapse.
It is through this repetition of booms, busts and sideways consolidations that the technical trader profits from the market.
Markets are also fractal in nature, and these cycles are seen not just on a longer timeframe, but on the smallest 1-minute bar chart also.
Does it work?
Technical analysis has a mixed reputation. Traders will swear by their charts, but generally, the academic financial community believes it offers little or no statistical edge.
For many in academia, the efficient market hypothesis is standard thinking, and TA flies in the face of their theories.
Many label it as nothing more than a pseudo-science.
Nevertheless, many traders have amassed vast fortunes through technical analysis.
From my own perspective, prices display randomness some of the time and non-randomness at others.
Predictive & reactive camps
There are broadly two camps in the study of technical analysis.
The first is the assumption that the study of price history can predict what will happen in the future, and also when it’s going to happen.
The second is the reactive camp.
By using trendlines, moving averages, and momentum a trader can jump on board as the price has already started moving.
Possibly the best way to make above-average returns in the market is via analysis of both disciplines simultaneously.
This is the preference for many buy-side institutions, deep-pocket players, and long-term stock market investors.
There’s no doubt riding a fundamentally driven trend is going to be more profitable than a none fundamentally one.
However, on a short-term basis, fundamentals have little value. Both day and short-term traders tend to ignore them and instead concentrate solely on the technical picture.
TA and the beginner
Technical analysis is a useful analytical skill for profiting from price moves.
It’s much less time consuming than fundamentals analysis. An experienced trader can look through many price charts in a matter of minutes.
But, the study of price charts can also be an effective risk management tool.
The violation of certain price levels (support levels) can inform a trader when a position is no longer likely to work out.
This means using a protective stop-loss at strategic price points to preserve capital. This is not so easy relying only on the fundamentals.
Understanding what is technical analysis, and the various sub-disciplines that make up the vast subject are vital for the new trader.
Certain methods are more fitting for short-term leverage than others and knowing which can mean the difference between success or failure as a new trader.