Technical analysis is the study of historical price data used to interpret and attempt to forecast future price movements.
As a concept, there are three key principals which form the basics of this approach (*Technical Analysis Of The Financial Markets, John Murphy, 1999, New York Institute of Finance).
1. Market action discounts everything
2. Price moves in trends
3. History tends to repeat itself
Market Action Discounts Everything
Technical analysis assumes that at any given moment in time anything that can possibly affect the value of a financial instrument (including but not limited to fundamental, political, and psychological factors, etc.) is already reflected in its price. Therefore, the only thing needed to consider when applying technical analysis is the analysis of the past price of the financial instrument.
Price Moves in Trends
Essential to this form of analysis is the concept that price moves in trends and that once a trend has been established it is more likely that price will continue to move in the direction of the trend than against it. One of the main reasons for applying technical analysis to a financial instrument is to identify the early stages of a trend for the purpose of trading in its direction.
History Tends to Repeat Itself
The view that history tends to repeat itself is attributed to human psychology. The use of identifying chart patterns (which over time have often repeated themselves) for the purpose of forecasting future price movement is believed to be relevant. If the chart patterns have worked well in the past, it is assumed that they will continue to work in the future.
Using these three concepts, technical analysis utilizes different techniques and tools to interpret and try to forecast prices. Some of the most commonly used forms of technical analysis are candlestick analysis, support and resistance levels, trend identification, chart patterns, and the application of technical Indicators.
Candlestick analysis is the practice of using the visual representation of price movement to help make trading decisions based on the possible short-term directional movement of a financial instrument.
Support and resistance are terms used to describe prices or areas on a chart that historically have caused prices to stop and reverse. A support level is a price at which buyers will tend to buy, whereas a resistance level is a price at which sellers will tend to sell. Armed with the notion that the markets tend to repeat themselves, locating these areas on a chart of the financial instrument can identify prices of potential interest for an investor.
As Trends form one of the key principles of technical analysis, being able to recognize and identify them is vital if technical analysis is going to be correctly applied. There are two types of trends in any financial instrument.
1. Uptrend – also referred to as a bullish trend, it is a period where price overall moves up. It is recognized by the movement of the market continually recording new Higher Highs and Higher Lows. Provided this structure within the chart is not broken, then the market is considered to continue in an uptrend.
2. Downtrend – also referred to as a bearish trend, it is a period where price overall moves down. It is recognized by the movement of the market continually recording new Lower Lows and Lower Highs. Provided this structure within the chart is not broken, the market is considered to continue in a downtrend.
Range – a time of investor indecision, is a period usually occurring after or during a trend when prices will move between similar Highs and Lows. Continuing to move in a choppy sideways motion, eventually the price will break out either towards the upside or downside to begin the formation of a new trend.
Chart patterns are specific price formations that have historically appeared prior to price moving in a particular direction. They are therefore used to identify potential areas of price continuation or reversal, which can be of interest to investors. Triangles, head and shoulders, pennants, wedges, flags, double tops, double bottoms, triple tops and triple bottoms are all common chart patterns used in financial markets.
Technical indicators use mathematical formulae to interpret historical prices and display their results on the financial chart. They are often used by technical traders and investors to identify prices and areas of potential interest. Some of the most well-known technical indicators include moving averages (simple MA, MACD, Bollinger Bands, Ichimoku Kinko Hyo, etc.), Momentum, RSI, and Stochastic.
Whilst technical analysis is incredibly versatile and can be applied to any financial asset and on any timeframe, it is subject to the interpretation of the individual using it. That is to say that two or more investors could draw different conclusions from looking at the same technical analysis. With that being said, it is a useful tool that can be applied in conjunction with other factors to help create a solid trading plan and informed trading decisions.