Technical analysis is the study of past price movements, using charts and other tools to identify patterns which suggest the possible future movements of prices. Instead of buying and holding for a long time horizon (months or years), users of technical analysis buy and sell within a short time horizon (from seconds to few weeks). This frequent buying and selling is termed as trading and the users are generally known as traders.
Unlike fundamental analysis, technical analysis is not concerned about a country’s economic data, a company’s business model, financial statements, or anything related to the company’s business. By analysing historical movements of prices in chart forms, and using various indicators and oscillators, traders make forecasts on future movements of prices and determine a good time to execute a trade.
Top-Down approach in Technical Analysis
Most traders use the Top-Down approach to filter and identify which financial product to focus on. For example, a trader could first analyse an economy from its index, based on the criteria set by the trader . Once the economy analysis passes the criteria, the trader will scale down to analyse the industries within the economy. Similarly, industries which pass the criteria would be chosen and further scaled down for individual stock analysis. After choosing a pool of stocks from the different industries, the trader will have to identify the ones with trading setups that fits his criteria.
Tools used in Technical Analysis
Here are some of the common tools used in technical analysis:
Charting is the study of market action and traders try to identify recurring chart patterns. The goal is to profit from trading when the patterns recur. Some traders work with bar graphs showing high, low, opening and closing prices, and volume and open interest, while some only track price changes and ignore time, volume and open interest. There are two main categories of chart patterns: continuation and reversal. Continuation patterns suggest trading in the direction of the current trend while reversal patterns indicate it is time to take profits on existing positions. However, some patterns can serve as either continuation or reversal formations. When several chart patterns point in the same direction, their signals are reinforced, and their signals cancel one another when different patterns give conflicting messages.
Support and Resistance lines are essential for understanding price trends and chart patterns. Rating their strength helps a trader to decide whether a trend is likely to continue or reverse. Support is the price level where buying is strong enough to interrupt or reverse a downtrend. When a downtrend hits support, it bounces off the line and moves upwards. Support is represented on a chart by a horizontal or near-horizontal line connecting several bottoms. On the other hand, resistance is the price level where selling is strong enough to interrupt or reverse an uptrend. When an uptrend hits resistance, it bounces off the line and moves downwards. Resistance is represented on a chart by a horizontal or near-horizontal line connecting several tops.
Trends exist when prices keep rising or falling over time. In an uptrend, each rally reaches a higher high than the preceding rally and each decline stops at a higher level than the preceding decline. In a downtrend, each decline falls to a lower low than the preceding decline and each rally stops at a lower level than the preceding rally. In a trading range, most rallies stop at about the same high and declines peter out at about the same low.
Technical analysis considers the market to be more psychological than logical, while fundamental analysis consider the market to be less psychological and more logical. Even though there are some universal principles and rules that can be applied, technical analysis is more an art form rather than a science. As an art form, it is subject to every individual trader's personal interpretation and perception. However, it is also flexible in its approach and each trader should use only that which suits their style. Developing a style takes time, effort and dedication, but the rewards can be significant.
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