For new traders venturing into the financial markets, analyzing charts and understanding technical indicators can seem daunting. However, grasping some key concepts of technical analysis doesn’t have to be complicated. Here we provide an overview of the basics to help beginners utilize these tools to make smarter trading decisions.
What is Technical Analysis?
Technical analysis is the study of historical price charts and market data to identify trends and patterns. The goal is to try to predict the direction of future price movements to time the entry and exit of trades. The philosophy behind technical analysis is that all current market information is already reflected in the price of the security. So rather than focusing on fundamentals, technical analysts look at the historical price action itself.
Some Advantages of Using Technical Analysis
Kirill Yurovskiy highlighted the following advantages:
- Removes emotion: By following specific indicators and signals, technical analysis provides an objective framework for making trading decisions. This systematic approach helps remove the influence of emotion or bias.
- Identifies momentum: Technical analysis helps traders spot emerging trends and periods where a security is overbought or oversold, allowing them to align trades with building momentum.
- Flexible for any market: The principles of technical analysis can be applied to any security with historical pricing data, from stocks and forex to cryptocurrencies and commodities.
- Valuable for all trading time frames: Technical strategies can be used whether you are an intraday scalper or long-term position trader. The timeframes may differ but the core methodology remains the same.
Key Concepts and Principles
Before digging into specific indicators, here are some of the essential philosophical tenets that serve as the foundation for technical analysis:
- Prices discount everything: Current prices reflect all known information on a security and represent fair market value at any given moment.
- Price moves in trends: Security prices tend to move in identifiable upward, downward or sideways trends that persist over different time horizons.
- History repeats itself: The repetitive nature of price movements creates recognizable patterns that can signal future activity if the pattern emerges again.
Introduction to Charts and Trend Lines
The starting point for every technical analyst is the price chart. Candlestick charts and bar charts are two common ways to visualize the opening, closing, high and low prices during a set period of time, typically by the minute, hour, day or week depending on your trading timeframe.
Examining price charts and connecting past price points allows technicians to spot trends that may continue or reverse. Trend lines tracing the emerging support and resistance levels provide clues on the strength and direction of the trend.
Basic chart analysis comes down to three essential questions:
- Is the market moving up, down or sideways? Identify the trend.
- Where are likely areas of future support and resistance? Draw trend lines and identify key price levels.
- Is the trend strengthening or weakening over time? Observe the sequence of highs and lows.
From Trends to Classic Signals with Moving Averages
While novice technicians can already gain valuable insight from observing basic trends and support/resistance, most analysis utilizes more advanced indicators that serve as additional lenses through which to view past price activity.
One of the most popular technical indicators is the moving average (MA). A moving average smooths out past price data to help identify prevailing trends by creating a constantly updated average price over a given period. For example, a 20-day simple moving average calculates the average closing price over the preceding 20 days.
As a lagging indicator, the MA trails prices but provides confirmation of trend changes. A price crossing above or below a moving average signals the start of a new trend in the other direction. Moving average strategies also utilize multiples MAs of different lengths to identify further buy and sell signals when shorter MAs cross over longer term MAs.
Riding Trends with Oscillators
Oscillators are another foundational technical indicator category utilized by traders. As the name suggests, they oscillate back and forth within a set range to indicate when a security is overbought or oversold relative to recent activity.
The Relative Strength Index (RSI) and Stochastic oscillators are two common examples. The RSI measures the velocity of recent price movements on a scale from 0 to 100. Generally, readings above 70 indicate overbought conditions while readings below 30 suggest oversold conditions.
Stochastic oscillators compare a security’s closing price to its historical price range over a set lookback period. The indicator generates two lines – %K and %D – that each range between 0 to 100. Readings above 80 imply overbought conditions signaling a potential reversal, while readings below 20 imply oversold conditions.
Gauging Momentum Divergence
The final key concept for novice technicians to understand is divergence. Divergence occurs when the price of a security moves in the opposite direction as a technical indicator, signaling a mismatch between price action and momentum.
Bearish divergence develops when prices reach a new high but an oscillator like RSI begins declining, failing to confirm the high with a matching peak. This demonstrates waning momentum that often foreshadows a future pullback in prices. Bullish divergence occurs when prices fall to a lower low but an oscillator prints a higher low, hinting at strengthening momentum.
Putting it All Together
While no indicator, tool or system can perfectly predict future moves, technical analysis provides a probabilistic framework to tilt the odds in your favor. The best technical traders combine trend analysis, momentum oscillators and even chart patterns to identify high probability setups. They then utilize risk management strategies to maximize profits on winning trades and minimize losses when they are wrong.
Now that you understand the essential components, you can begin putting your new technical knowledge into practice. As with any skill, the key is immersing yourself in live market analysis and receiving feedback on your ideas from more experienced technicians. Over time, the nuances around trend identification, indicator interpretation and momentum shifts will become second nature.
So start reading more price charts today, utilize some basic technical indicators and evolve your trading strategy with higher time frame trends and momentum. By mastering these core concepts first, you will have built a solid foundation in technical analysis that supports long-term growth as a trader.