nvestors and traders have used technical analysis for over a century to try and
predict future market movements.
In fact, there’s some evidence traders and investors were using technical analysis to inform their decisions decades before fundamental analysis, which relies on a company’s financial fundamentals, became a widely used and accepted method of understanding companies.
According to the CFA Institute, technical analysis relies on three
fundamental principles:
Another factor that helps support technical analysis is behavioural finance. This is the study of psychology's influence on investors' behaviour. More often than not, technical analysis works because there are so many market players looking at the same trends.
And that, in a nutshell, is why technical analysis is such an essential tool for investors and traders.
It can help produce an insight into how the rest of the market is thinking and how the rest of the market might react in the near future. Although, as is the case with everything in the world of finance, nothing is guaranteed.
The tools of the trade
The primary tools used in technical analysis are charts. Then, there are indicators, designed to help read and understand charts.
Charts give us an insight into basic price movement over a certain period. You can use charts to analyse price movements over a couple of hours, a couple of days and even weeks or years. Ultra-long-term trends, such as commodity market cycles, can last over a decade and charts can help identify these patterns.
Charting tools can also provide information about trading volume. This is a valuable tool for traders and investors because it gives an insight into the demand for a security and liquidity of that particular asset.
High volume can signal a shift in investor sentiment, while low volume can signal an illiquid or unloved asset. Buying and selling illiquid assets can be difficult, and this may force investors to reconsider their strategy.
The ‘trend’ is the most crucial insight charts generally provide. As noted above, one of the key tenets of technical analysis is the belief asset prices move in trends.
For example, if the price of a stock has been going up continually for a week, it may continue to do so as traders follow what’s known as ‘momentum’. Investors may also keep buying as a higher price will validate their trading hypothesis.
An uptrend is defined as a sequence of higher highs and higher lows, while a downtrend is defined as a sequence of lower highs and lower lows.
Most of the tools technical analysts use are based on the principle of the trend. Analysts will use tools such as strength analysis (the strength of the trend), support and resistance to judge how strong the trend is and when they should buy and sell.
The ‘trend’
These momentum and strength indicators can be combined with support and resistance lines on charts.
Support and resistance lines give traders and analysts a good idea of where prices may encounter buying and selling pressure, which may change the direction of the overall trend. These levels can be helpful for both investors and traders planning their deals.
Technical analysts and traders may also use specific patterns on charts to help identify trend lines and the future direction of a security.
Common patterns include the head and shoulders pattern, used to signal the reversal of a trend, and trend lines, used to plan entry and exit levels for traders.
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Why technical analysis is such an important tool for investors and traders
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Seen as an increasingly important part of most investment house activity technical analysis helps forecast the direction of financial market prices. According to several studies it has a greater success rate than fundamental analysis, especially in shorter-term time frames of less than three months' duration. Technical analysis can be applied in any market that is liquid and is a vital investment tool which gives me an edge. I wouldn't trade without it! When used correctly, technical analysis can be used not just for market forecasts but, more importantly, for correct risk and money management.
Common strength indicators include the Relative Strength Index (RSI), moving averages and
Bollinger Bands.
The RSI tells traders about the strength of a trend of an asset and can signal if that asset is overbought or oversold.
Moving averages give an average of price changes over a specific time frame and can be a great way of analysing how strong the trend is over a longer term.
Technical analysts often look for signals in moving averages, such as what's known as The Golden Cross, when the 50-day moving average crosses over the 200-day moving average and both are pointing in the same direction, down or up. This particular signal can indicate the beginning of a substantial long-term trend, either to the downside or the upside, depending on the signal given.
Axel Rudolph
Senior Market Analyst - IG UK
The market discounts everything
Asset prices move in trends
History often repeats itself, and price action can be repetitive (although past performance should never be used as a guide to future returns)
Bollinger Bands are a bit more complex. They combine the concept of a moving average with standard deviations around the moving average. They can give analysts an idea of the overall trend of a security as well as volatility, helping traders to analyse their risk exposure.
The ‘trend’ is the most crucial insight charts generally provide. As noted above, one of the key tenets of technical analysis is the belief asset prices move in trends.
For example, if the price of a stock has been going up continually for a week, it may continue to do so as traders follow what’s known as ‘momentum’. Investors may also keep buying as a higher price will validate their trading hypothesis.
An uptrend is defined as a sequence of higher highs and higher lows, while a downtrend is defined as a sequence of lower highs and lower lows.
Most of the tools technical analysts use are based on the principle of the trend. Analysts will use tools such as
strength analysis (the strength of the trend), support and resistance to judge how strong the trend is and when they should buy and sell.
Common strength indicators include the Relative Strength Index (RSI), moving averages and Bollinger Bands.