Technical analysis is the methodology of forecasting future price movements of financial assets based on past price action. Technical analysis is largely the study of market action, primarily through the use of charts for the purpose of forecasting future price trends. This is done by analysing past price action to identify expected zones or supply and demand. The study of price charts is the main tool of the Technical analyst.
Example of technical analysis:
Advocates of technical analysis often cite the saying “price action discounts everything” which means that the price of an asset already reflects/discounts anything that could possibly effect the price. Price discounts the hopes and fears of market participants, their expectations for the future fundamental performance and political events (this is also the basis of efficient market hypothesis). So if the price discounts all possible factors then the analysis and study of price is all that is needed to forecast the market. It’s all about identifying areas of price that have a high probability of there being supply or demand. It can be used on any market, Forex, Stocks, Commodities, Virtual Currencies, Bonds.
Why does technical analysis work?
Well technical analysis doesn’t work all of the time, but can be used as a tool to help identify where there is likely to be supply and demand. Seen as price is a reflection of the behaviour of market participants and behaviours are usually repeated we can make an educated guess on what price will do in the future based on the past. Also, everyone can see the same technical signals as each other, creating a crowd of traders that are watching a level of supply and demand, acting together to buy and sell together at those levels.
Technical analysis can also be a kind of self-fulfilling prophecy, for instance, say that the price is moving lower and is approaching the 200 weekly moving average, many traders will see this technical support at buy when price is near. Therefore traders using technical analysis are unknowingly acting together to support the price at this level; price is then likely to bounce given the volume of buy orders coming in at that technical level. This then fulfils the prophecy of the technical analysis.
It’s not rocket science!
Technical analysis in its most basic form is traders drawing support and resistance levels and trend lines. It’s not rocket science to draw a few lines on a chart and make trades based on how price interacts with these drawings.
Many traders make the mistake of making their technical analysis too complicated in the belief that stringing together a series of indicators will give them the Holy Grail. There is no Holy Grail. Keeping it simple is the key to effective technical analysis.
For example let’s take Goldman Sachs, they are the world’s most famous hedge fund, let’s look at how they do it.
A couple of horizontal areas of support, an oscillator that gives new longs something to think about and some Elliot wave thrown in for good measure. A very clean chart that says you can get long after the retest of support but be cautious.
So there is it is, keep it simple, you don’t want your chart to end up like this:
Having too many technical drawings on one chart makes it difficult to see what is happening and can be distracting when you come to make a trade.
It’s a trap!
Now that we know everyone is looking at the same technical studies, I offer a word of caution; the “big boys” are looking at the same technical’s you are and are aiming to trap you! When I say “Big Boys” I mean the players that have the power to move the market with their trades, the hedge funds of this world. They are always looking for liquidity and will sometimes wait for a technical signal to hear its head and then take the other side of the trade, trapping traders who are executing off these signals. This is often the case with false breakouts. The way to combat this is to have prudent risk management techniques in place to limit your risk e.g. using a stop.
Example of a false breakout:
Only use technical analysis to trade?
Some traders do and it can work, but to get very high probability trades your should include other factors into your decision making.
While Technical analysis can be very effective, it should be used as part of your tool kit, taking into account fundamental analysis, news, sentiment and marketing positioning.
Manage your risk!
Once you have mastered the basics of technical analysis and price action to place your trades, the game becomes about risk management and sizing of trades. You are not going to make money on every technical signal you act on, so you need to protect your capital by managing your risk. And at the same time, upping you trade size when you have a high conviction trade to make the most of high probability setups.