Since we have defined and examined the history of technical analysis in a previous post, it is time to go deeper and talk about the principles of technical analysis. Let us begin to build the foundation to be able to trade using technical analysis successfully. As a trader, it is crucial to understand when and how to use technical analysis in trading. This post examines the fundamental ideas and principles that all traders, whether new or experienced, should know whether they choose to use only technical analysis or a combination of fundamental, sentimental, and technical analysis. In layman’s words, the following are some principles that a trader using technical analysis must understand.
Market Structure
Market structure refers to the general organisation and behaviour of price movements in financial markets. It is a critical notion that assists traders and investors in understanding the present market situation, identifying prospective opportunities, and making sound trading decisions. Some people boast that they look at an asset’s charts for 5 minutes and can decide whether or not to trade the asset, which is most likely due to their mastery of market structure recognition. As much it is possible for experienced traders to analyse the market structure and make trading decisions relatively quickly, it is important to note that successful trading requires more than just the knowledge of technical analysis. However, understanding market structure as described above sounds like a superpower to have as an investor.
There are two main types of market structure namely the trending and ranging market structure.
In a trending market, the price of an asset is moving in a clear and defined direction, either up (in an uptrend) or down (in a downtrend).
In a ranging market, the price of an asset is moving within a relatively tight range, with neither buyers nor sellers in control of the market.
Price trends
Have you ever heard the phrase “The trend is your friend”? This is one of the most common phrases in the investment world. Most traders use the phrase to teach trend following or trend trading styles. One of the primary objectives of technical analysis is for a trader to be able to identify trends in price movement. Some argue it is more profitable to spot trends in their early stages and be on the right side of that trend as the ship of the trend sails on. Traders look at the chart of any given asset to identify one of these three trends: upward, downward or sideways. In trading, a trend refers to the general direction of a market or asset’s price movement over a period of time.
As a Trader or investor, you can use trend analysis to identify and capitalise on market opportunities. For example, using technical indicators such as moving averages, trendlines, or chart patterns to identify when a trend begins or ends and take positions accordingly. Understanding the direction of the trend can help traders and investors make more informed decisions about when to buy or sell assets.
Support and resistance levels
These are locations on an asset’s price chart where the price has historically struggled to break through. Support levels are areas where buyers are gathered and ready to join the market. In contrast, resistance levels are areas where sellers are assembled and prepared to enter the market for a short or sell position.
Many technical analysis methods, including trendlines, moving averages, Fibonacci retracements, and chart patterns, can be used to identify support and resistance levels. It’s crucial to remember that support and resistance levels aren’t always perfect, and an asset’s price might occasionally break through whatever support or resistance levels a trader has identified. As a result, stop-loss orders are frequently used by traders to control risk and preserve their positions. Below is an example of how support and resistance look on a chart.
Chart patterns
The price action of an asset forms chart patterns over time. These patterns can indicate the continuation or reversal of trends. Chart patterns are one of the most popular tools used in technical analysis and can help traders and investors identify potential trading opportunities and make informed decisions about when to buy or sell an asset.
There are two main types of chart patterns: continuation patterns and reversal patterns. Continuation patterns, as the words suggest, indicate that the price trend is likely to continue, while reversal patterns suggest that the trend is likely to reverse.
Some common continuation patterns include:
- Flags and Pennants: These patterns are characterized by a period of consolidation after a sharp price movement, followed by a continuation of the original trend.
- Triangles: These patterns are formed by two converging trend lines and indicate a continuation of the current trend.
- Trend Channels: These patterns are formed by parallel trend lines that contain the price movement of an asset and indicate a continuation of the current trend.
Some common reversal patterns include:
- Head and Shoulders: This pattern is characterized by a peak (the head) with two smaller peaks on either side (the shoulders). It suggests that the current trend is likely to reverse.
- Double and Triple Tops/Bottoms: These patterns are formed by two or three peaks or valleys that are roughly equal in height and suggest that the current trend is likely to reverse.
Chart patterns and other technical analysis techniques like moving averages, trendlines, and support and resistance levels are used by traders and investors to validate prospective trading signals and enhance their trading selections. However, it is crucial to note that chart patterns are not flawless and should be used alongside other kinds of analysis to reduce risk and enhance performance.
These are the primary components that I feel are required for basic technical analysis knowledge. Nevertheless, some more tools exist as part of understanding the price movement using technical analysis.
- Moving averages: Moving averages are a popular tool used by technical analysts to smooth out price data over a given period of time. They help to identify trends and potential support and resistance levels.
- Relative strength index (RSI): The RSI is a momentum indicator that compares the magnitude of recent gains to recent losses in an attempt to determine the overbought and oversold conditions of an asset.
- Fibonacci retracements: Fibonacci retracements are based on the idea that markets tend to retrace a predictable portion of a move, after which they may continue in the original direction.
- Volume: Volume is the amount of an asset that is traded within a specific period. Technical analysts look for changes in volume to confirm or disconfirm trends and other technical indicators.
Conclusion
Overall, technical analysis is a powerful tool that can help traders and investors make better decisions in financial markets. By studying charts and other technical indicators, analysts can identify trends, support and resistance levels, and other key factors that can inform investment decisions.