Technical analysis is the visual study of market prices in order to anticipate future directional movement in price. Technical analysts believe that price is reflective of all current information and that the majority of this has already been factored in to the value of an asset. Therefore, the study of price action taking into account this supposition will allow practitioners of technical analysis to determine future prices.
Technical analysis is more of an art form than an objective science and experienced technical analysts can use familiarity of historical price action to reliably anticipate future price movements as well as supporting decisions to enter and exit positions and in the management of risk.
Technical analysis uses both objective and subjective studies of price action. Studies of trend following, means reversion, and momentum are included in the objective analysis whilst pattern recognition and the establishment of support and resistance form the subjective elements of technical analysis.
Trend following analysis focuses on historical prices to establish if a financial instrument is trending. Trends can be defined as the specific and definitive direction of price over a period of time. Trends can exist on all timeframes and those found on higher timeframes can last a matter of weeks and months. Moving averages provide a good analysis of historical trends. They are calculated over a period of time, taking an average of price across these with the most historical data being excluded from the calculation as the time period extends. Therefore a 20 day moving average would not include the data for the 21st day prior and beyond this would not be included in the calculation.
An example of using trend analysis to determine whether a trend exists is the crossover method using a short moving average and a long moving average. Shorter moving averages, using only a few days’ historical data, will move closer to the current price. Therefore, when a 10 day moving average shifts from below the average of 40 days’ average, crossing over and rising above this, the financial instrument can be considered to be in an uptrend. This, however, should not be used exclusively as a trading signal, as these are often false signals of a new trend. Saying this, however, when a trend is established the movement of price will generally far outweigh any losses incurred on false trend signals. With correct money management and risk calculations, a strategy that’s only profitable 33% of the time but generating five times the level of profit relative to the losses incurred on the majority of trades, then it will form a profitable system.
Momentum indicators can be considered as leading indicators which offer signals of future price direction. These are converse to moving averages which are lagging due to their reliance on historical data, and therefore prove to be a popular tool to establish trend, and especially the start or end of a trend in the moving average convergence divergence (MACD). This specific strategy creates a measure of momentum, measuring the daily changes between a short moving average and a long moving average. When momentum increase the MACD will rise, showing that the short moving average is moving away from the longer moving average, and vice versa when the MACD falls.
Mean reversion strategy employs the theory that when price moves far enough away from its average price, usually with increased volatility, it will almost certainly correct and fall back to this at some point in the future. The analogy of this is stretching rubber bands which are always exerting pressure to snap back the further that they are stretched. Bolinger bands are the technical tool to analyse potential trades using this technique; they form two channels, based on standard deviation, above and below price which can be considered the outer boundaries of price. When price hits these levels, it will have a high probability of returning back to the central region of the two bands.
Other indicators which measure means reversion are oscillators such as the relative strength index (RSI) and Stochastic indicator. Such technical indicators quantify momentum of the market relative to short term and long term price movements. When the index on which these are based becomes overstretched, they signal that a financial instrument may be oversold or overbought.
Pattern recognition is commonly used in technical analysis. It looks for patterns which have had historical reliability in predicting future price action. The patterns formed will show the sentiment of the market over a period of time and the more familiar the pattern to traders, the increased likelihood that it will successfully determine future price movements. ‘The head and shoulders’ pattern is popular and reliable in showing a market losing upward momentum by creating two smaller peaks as the shoulders and a central peak as the head. Price has a tendency to drop off the right-hand shoulder and move significantly lower.
Support and resistance are more subjective in technical analysis. It broadly employs the use of trend lines to establish where price will rise or fall. Trend lines are generated by linking the lows or the high of a trend.
Technical analysis can be highly useful in creating a trading strategy or as confirming signals to other means of financial market analysis. It reflects the sentiment of the other market participants and this is shown in a variety of trend, momentum and mean reversion and pattern recognition. This article has introduced the basics of a few of these techniques. There exists a wealth of information including books on both technical as well as fundamental analysis, which can help traders to gain a deeper understanding about how markets move and in developing their own trading strategies.