1. What is Technical Analysis?
Technical analysis (TA) is the study of price history and trading volumes in order to identify patterns that predict price movements. Technical analysis is applicable to any asset with a history of past price changes, including cryptocurrencies, fiat money, commodities and stocks.
2. Who developed technical analysis and when?
Primitive forms of technical analysis appeared in Amsterdam in the 17th century and in Japan in the 18th century. Modern TA originated in the writings of American journalist Charles Dow, founder of The Wall Street Journal. Dow was one of the first to notice that assets and markets often develop in trends which can be fragmented and analyzed. Based on his observations, he created a concept known as Dow Theory.
3. The key tenets of Dow’s theory are
- Pricing is driven by everything that happens in the market; all present, past and future factors (demand, regulatory changes, market participants’ expectations, etc.) are already factored into the current price of an asset and trading volume. The study of price/volume dynamics is sufficient for predicting the likely development of events in the market.
- The main thing is the “what,” not the “why. The focus of the technical analyst is the price of the asset, not the various variables which produce the price movement. Price is a reflection of the opposing forces of supply and demand, which are closely related to the emotions of fear and greed of market participants.
- Price movements are not haphazard, but subject to trends. The aggregate of changes in the balance of supply and demand over a certain period of time forms trends (short-, medium- and long-term). If demand exceeds supply, there is an upward trend; if supply exceeds demand, there is a downward trend. When supply and demand balance each other out, there is a sideways price trend (flat).
- History tends to repeat itself. Market psychology can be predicted as traders stereotypically react to similar factors.
4. How does technical analysis differ from fundamental analysis?
Unlike the TA approach, where price histories and trading volumes are paramount, fundamental analysis (FA) is designed to assess the intrinsic value of an asset and considers not only quantitative but also qualitative factors, including:
- financial and operating performance;
- a company’s management and reputation;
- market competition;
- the general state of the industry, etc.
Based on this data, future performance of the asset is predicted.
FA is more effective and reliable in markets operating under normal circumstances, with large trading volumes and high liquidity. Such markets are less susceptible to price manipulation and external influences that produce false signals and make TA of little use.
Technical analysis is mainly used as a tool to forecast price movements and market behavior, fundamental analysis is used as a method to assess the value of an asset according to its potential and context.
TA is popular among short-term traders, FA among stock managers and long-term investors.
5. How does technical analysis work?
Technical analysis examines and analyzes patterns, which are typical patterns that are formed on price charts (Double Bottom, Triangle, Flag, etc.), as well as levels, often based on previous highs or lows in prices. As prices approach previous highs or lows, market participants expect similar reversals and tend to place trade orders, which in turn generates resistance and support levels.
For technical analysis of prices, levels and patterns charts are used, which show the change in prices over a certain period of time. The most popular among traders are Japanese candlestick charts, line charts, as well as histogram charts (bars).
Japanese candlesticks can be used as independent patterns of TA, or in combination with additional tools – geometric shapes, indicators, oscillators, etc.
Patterns are usually detected by traders independently on charts, without the use of auxiliary mathematical tools.
6. Additional TA instruments
- Horizontal line – a straight line indicating price levels on the chart.
- Trend line – a sloping straight line for trend detection.
- Calculation lines formed on the basis of mathematical processing of key values specified by a user (Fibonacci levels, Gann lines).
7. Technical Indicators
Technical indicators – additional charts, formed on the basis of recalculation of values, contained in the base price chart. They have at least one variable parameter, the value of which can significantly change the displayed results. The following indicators and metrics are used within the TA:
Simple Moving Average (SMA), which is calculated based on the closing price at a set time.
Exponential Moving Average (EMA) – a modified version of the SMA, which takes into account the most recent rather than the oldest closing prices.
Relative Strength Index (RSI) – a kind of indicators known as oscillators. Unlike simple moving averages, which simply track price changes over time, oscillators apply mathematical formulas to price data, obtaining readings that fall within preset ranges. The RSI has a range of 0 to 100.
Bollinger Bands (BB) – an indicator consisting of two sideways bands, which circle a moving average. It is used to identify potential overbought and oversold market conditions, as well as to measure market volatility.
Along with basic and simple tools, TA uses tools based on other indicators:
Stochastic RSI is calculated by applying a mathematical formula to the regular RSI.
The Moving Average Divergence Indicator (MACD) is generated by subtracting two Exponential Moving Averages (EMAs) to create a main line (MACD). The first line is then used to generate another EMA and a second, signal line is generated. There is also a histogram (a graphical representation of the statistics) of the MACD, calculated based on the differences between these two lines.
8. Trading Signals
Indicators, in addition to helping identify general trends, provide data on potential entry and exit points (buy and sell signals). Signals are generated when certain events occur on an indicator chart. For example, a Relative Strength Index (RSI) value of 70 or more may indicate an overbought market, while a drop in RSI to 30 or less usually indicates an oversold market.
9. The disadvantages of TA
The trading signals provided by TA are not always accurate. Indicators create a significant amount of “noise” (false signals), which is especially true for cryptocurrency markets, which are much smaller and more volatile than traditional financial markets.
Critics refer to TA as “self-fulfilling prophecy,” that is, predicting events that only happen because a large number of people assume a certain scenario is likely. Because numerous traders and investors use the same indicators, such as support and resistance levels, these patterns become workable. On the other hand, each trader analyzes market charts in his or her own way, using the many indicators available. This means that a large group of theanalysts cannot use the same strategy.
Although TA deals with empirical data, it is not free from the influence of bias and subjectivity. A trader predisposed to certain conclusions about an asset may well manipulate the tools to bolster his viewpoint. Quite often this is done unconsciously. Also, technical analysis fails at times when the market does not provide distinct patterns or trends.
Many consider a combination of FA and TA to be the most rational approach: the first method works well for long term investment strategies, the second for short term trades.