Technical analysis predicts what price will do in the future based on charts and data from the past. What kind of sorcery is technical analysis and does it really work?
In this blogpost I’ll explain what technical analysis is and how you can benefit from it as a trader or investor.
Difference between technical analysis and fundamental analysis
As a trader you want to make as much profit as possible by buying and selling at the right time. To achieve this goal you have to predict what the price of (for example) a share will do in the future, so you can enter and exit at the right time.
But how can you predict whether price will rise or fall? As a trader you have two options:
- Fundamental analysis
- Technical analysis
With fundamental analysis you look at the background of the asset of which you want to predict the next price movement. Suppose you are interested in the Heineken stock, then you start digging into that company’s financial figures.
You also keep an eye on the news and look at the future plans or possible acquisitions. Based on this information you can make an educated guess, on which you can decide to buy (go long) or sell (go short).
Technical analysts are not concerned with this, they look at completely different things …
What is technical analysis?
Technical analysis is looking price movements from the past to predict what the price will do next.
Technical analysis is not bulletproof and therefore never 100% accurate. It is meant to help you make an educated guess. As long as you get it right more often than wrong and you win more on your winners than you lose on your losers, you make a profit.
Technical analysis is therefore not an exact science!
Technical analysis software
For technical analysis you have to be able to analyze charts and data. And that means you need software to visualize those charts and be able to draw on them, etc.
Fortunately all online brokers nowadays offer a free trading platform including technical analysis software and charts. Usually you get immediate access when opening a demo account.
In most technical analysis software you can set the gchart so that it displays the price in so called candlesticks . This way of displaying price is originally from Japan and owes its name to the fact that they resemble candles, with a body and a wick.
These candles represent the price movement over a certain period. Candlesticks come in three colors:
- Rising / bullish candle (often green)
- Falling / bearish candle (often red)
- Unchanged candle (often white or black)
With a rising candle, the bottom of the body is the opening price and the top of the body is the closing price. With a falling candle, the top of the body is the opening price and the bottom of the body is the closing price of the relevant period.
If you set the chart to 5 minutes each candle is 5 minutes and if you set it to 1 day each candle represents 24 hours.
The wicks on the top or bottom of the candle show us what the highest and lowest point of the price was within the chosen period.
Candles already tell you a lot about price and what it could possibly do in the future. Learning how to read candlesticks is therefore the first step in technical analysis.
Once you are familiar with candlestick analysis, the next step is to identify trends. Here you ask yourself the question whether the price promotion moves up, down or sideways.
The answer to this question also contributes to your technical analysis about what price will do next.
You can mark this trend in your software or your chart by drawing a diagonal line. You can then use those lines as a visual aid to find trade setups.
Support and resistance
Another important factor in technical analysis is the identifying support and resistance levels. This can be the top or bottom of a trend, but the strongest support and resistance can be found on horizontal levels.
In short, these are points on your chart where price has clearly bounced off in the recent past.
I hope you can see that support and resistance is an indispensable part of technical analysis to determine what price could do in the future.
Support and resistance plays an essential role in my own strategy.
Finally, for technical analysis you can also choose from hundreds of different indicators. These indicators calculate price data from the past and give a signal about what the price could do in the near future.
I am not a fan of indicators and I hardly ever use them in my trading strategy, but some investors swear by them.
Often several indicators are used together to create confluence . This means that a trader buys or sells if multiple signals line up.
Popular indicators are:
- Moving averages
- Bollinger bands
Technical analysis in a trading strategy
Technical analysis is used as the basis for a trading strategy. I say basis, because a strategy consists of much more than just price bouncing off a support level.
For example, you can trade breakouts or reversals based on support and resistance, but apart from that you will also have to make rules for yourself for things like risk management. You must therefore see technical analysis as part of your strategy.
Backtesting technical analysis
The nice thing about technical analysis is that you can backtest it. Once you have determined the rules on which you are going to buy or sell within your strategy, you can scroll the chart to the left and replay the history for each candle.
Get in and out according to the rules within your strategy and follow the signals you get from your chart. After a while you can see exactly whether your strategy is profitable or not.
Advantages and disadvantages of technical analysis
I can imagine after reading this it might look fantastic. Draw a few lines on a chart, buy or sell and watch the money flow in. Unfortunately it doesn’t work that way. Technical analysis can help you enormously as a trader, but there are certainly disadvantages.
As mentioned, it is not an exact science and certain things can also stop working within certain market conditions.
Technical analysis is also quite a subjective process, because every trader interprets their charts differently. What is a valid setup for one might not look the same to the other.
Many indicators are what they call lagging indicators. They only send a signal when the price movement has already started, which increases the risk of getting into a trade. This is also the main reason that I do not use indicators myself.
There is a great danger in using too many indicators. They can contradict each other and you’ll get the wrong signals.
Practicing technical analysis
Whatever strategy you choose and how you will use technical analysis, always practice first. Every self-respecting broker nowadays offers a demo account with which you can practice any strategy with play money.
Questions about technical analysis? Ask them in the comments.