Understanding technical analysis

Understanding technical analysis

Some traders define themselves by how they find their trading opportunities. In this course, we’re going to cover one of the most popular methods – technical analysis.

What is technical analysis?

Technical analysis is a method of identifying trading opportunities that rely on reading price charts. Technical traders use these charts to determine the future direction of a market, as well as possible entry and exit points for each position.

Technical analysis vs fundamental analysis

Technical analysis is one of the two main ways in which traders analyze the market; the other is fundamental analysis. They represent very different methods for assessing assets and finding new positions.

  • Technical analysis involves looking purely at market prices and patterns, ignoring all other data
  • Fundamental analysis involves researching what is driving market price action, taking earnings, economic data, and more into account

You can use either approach in isolation, or a mixture of the two. Many traders, for example, will use fundamentals to find underpriced markets – then use technical analysis to plan exactly when to enter and exit their position. At each extreme, though, some use pure technical analysis and others are solely fundamental traders.

In recent years, new market research methods have begun to gain traction, such as sentiment and statistical analysis. But for now, most traders stick to one of the main two methods.

The basis of technical analysis

No trader has a crystal ball that they can use to see what will happen next in the markets. Instead, they use available information to make an educated guess about the future price action of their chosen asset and then weigh up the risk against the potential reward from the resulting trade.

Purely technical traders believe they can find all the information they need to determine the future direction of a market within its price chart.

Order in the chaos

The basis of technical analysis comes partly from Chaos Theory – the hypothesis that identifiable patterns will repeat in even the most chaotic-seeming areas. Instead of making concrete assertions about market behaviour, technical traders use these patterns to determine the probability of a certain move.

Based on this probability, they can decide whether a trade is worth the risk.

To technical traders, a price chart gives an insight into a market’s general sentiment on a given instrument. They decide on its future direction by combining that with what has happened previously.

Say, for example, that a strong EUR/USD rally is followed by a period of consolidation. A technical trader might see this as evidence that the positive sentiment is waning. If this pattern has shown a tendency to lead to price reversals in the past, then they might see that as a chance to open a short position.

Benefits of technical analysis

One of the main advantages of technical analysis is that it is considered a neutral trading tool. You can apply it to virtually any instrument over any timeframe, and it doesn’t rely on an analyst’s forecast. Whether you’re scalping forex or investing in stocks, you can make use of technical analysis to find and plan trades.

It can also provide an excellent method of determining your entry and exit points for a position.

As we’ve seen in earlier courses, a market rarely moves in a straight line. Instead, it’ll zigzag – either sideways, upwards, or downwards. If you can use technical analysis to time your trades within these zigzags, you’ll be able to push profits further.

Or, even better, you might be able to use technical analysis to spot when overall sentiment on a market is reversing.

Drawbacks of technical analysis

Because it relies solely on price charts, the technical analysis only looks at what has happened in the past when predicting what might happen in the future.

But just because something has happened before, it doesn’t mean that it will reoccur – the factors surrounding a pattern may be different this time, or an external event might impact the market in a wholly unpredictable way.

A pure technical trader, for example, might see their position adversely affected by some poor employment data that sends a currency plummeting. A fundamental analyst, meanwhile, would have paid more attention to this external price driver.

There is no single ‘magic’ approach to the forex market that will always yield positive results. The secret of successful trading is good risk management, discipline, and the ability to control your emotions.

Key concepts of technical analysis

There are hundreds of trading tools that a technical trader can utilize, but it all boils down to identifying support and resistance, trends, and ranges.

Support and resistance

Support and resistance are areas on a market’s chart that it has difficulty breaking past. If a market reaches its support or resistance level, then a price reversal may be on the cards.

Trends and ranges

Markets can only be in three states:

  • An uptrend, is when prices are rising overall
  • A downtrend, when prices are falling overall
  • A range, when prices are stuck between support and resistance

By using indicators and patterns, technical traders aim to spot when new trends are forming.

No trader has a crystal ball that they can use to see what will happen next in the markets