Understanding technical analysis
Technical analysis is a method of predicting the future direction of a market’s price, by studying historical chart patterns and formations.
In its truest form, technical analysis disregards any fundamental information on an asset that cannot be found on its price chart. Instead, a set of tools known as technical indicators are overlaid onto a chart to identify recognisable price patterns.
A technical analyst believes that those price patterns will tend to repeat themselves in the future. So they’ll analyse a market’s previous price movements, and use those to decide when to open and close trades to maximise their profits.
Differences between fundamental and technical analysis
A fundamental analyst plans their trades in a completely different way to a technical analyst. Instead of examining previous price movements, they’ll take various internal and external factors into account to decide how much they think a particular asset is worth. If the current market price of the asset is below what they think it is worth, then they’ll buy. If it is over what they think it is worth, they’ll sell.
For example, say a fundamental and a technical analyst were both considering trading Apple shares.
A fundamental analyst might examine Apple’s recent earnings reports, how its sector is performing, and the health of the economy as a whole before deciding how much they think Apple shares are worth.
A technical analyst would disregard all of that information, and pay attention solely to Apple’s chart. They would use technical indicators to find patterns that would give an insight into where Apple shares are headed next, and trade accordingly.
At first, technical analysis might look a lot simpler than fundamental analysis. After all, you only have to examine a market’s chart instead of poring through news, economic reports and earnings releases. But a successful technical trader might utilise a huge range of indicators – and may even backtest their strategy to make sure that it’s fit for purpose – before they trade. So it isn’t always the easier option.
Advantages of technical analysis
1. It's flexible
You can use technical analysis on almost any market – all you need is a price chart with some technical indicators. So whether you want to trade stocks, indices, forex or cryptocurrencies, technical analysis can be of use.
Technical analysis can also be used for both short and long-term trading. A long-term trend investor might use technical indicators to decide when to buy shares for their portfolio, while a short-term day trader could use them to identify quick opportunities for profit.
2. You can backtest it and automate it
If you want to see how your technical strategy would perform before risking any actual capital, you apply it to a market’s previous price movements. Backtesting involves taking a chunk of real data from a selection of markets, and running your strategy against it.
If you’re really confident in how your strategy will perform, you could even consider automating it – setting up a series of algorithms to trade with minimal involvement from you.
3. You can combine it with fundamental analysis
Most traders won’t stick to pure technical or fundamental analysis – they’ll employ a mix of the two to ensure they have a fully balanced view.
For example, you could use fundamental analysis to pick the market you want to trade, and after identifying your opportunity, use technical analysis to decide when you should open your position. Timing is a crucial part of successful trading, and technical analysis can help you time your trades to maximise profits and minimise losses.
Using charts in technical analysis
Technical analysis charts will usually show price movement in the form of candlesticks, which illustrate key points about a market’s price in a given period of time. The colour of the candlestick denotes whether it has moved up (green) or down (red) in price, and the bars on the candlestick show the opening, closing, highest and lowest prices.
There are many different indicators that technical analysts will use on charts. Here we’re going to take a look at two of the most popular technical analysis indicators: support and resistance, and moving averages.
Support and resistance
Support and resistance levels are areas on a chart that a market’s price has difficulty breaking through. Support is found when a falling market hits a given level and bounces; resistance is formed when a rising market hits a high and falls.
The more times that a market hits a point of support or resistance and reverses, the more reliable that projected line will be for future support or resistance levels. And when an established support level is broken, it may turn into a resistance level, or vice versa.
For example, say that Apple’s share price has hit $170 repeatedly, but always moved lower when it does. $170 would be a key area of resistance for Apple. If Apple then broke through $170 and on to new highs, it might turn into a key area of support – meaning that Apple’s share price could bounce when it hits $170.
Another commonly used indicator is the simple moving average (SMA). This is the average price of a market over a given period of time, which can be used to identify significant support or resistance levels.
The most popular periods used for calculating moving averages are 50, 100 or 200 days. As a market increases in price, the SMA can act as a significant area of resistance. If it is in a down trend, the SMA can act as an area of support.
Using our Apple example again, if Apple shares are trading at $170 and the 100-day SMA indicates a key area of resistance at $165, then you may want to consider placing a stop just below $165. Then, if Apple shares break below the area of resistance identified by the moving average, your stop would close out your position before a potential larger move lower.