Technical analysis - basic methods and principles

Why trade with technical analysis

 

There are several reasons to get started with technical analysis, but the main ones include the following.
 

Relative simplicity

Compared to other analytical approaches to financial markets, technical analysis is relatively simple and quick to learn. It often does not require any paid programs or information resources, and you can find plenty of free educational materials on the internet. Thanks to technical analysis, you can start trading in just a few weeks and gradually improve your skills.
 

Versatility

Technical analysis can be used for virtually any type of market from Forex, stock indices, equities, and commodities to cryptocurrencies. You can also use it for scalping, intraday, or swing trading strategies.

Mitigating emotions when trading

Trading is psychologically a very strenuous discipline. Emotions such as greed or outright fear can significantly impair the trading results of traders, and traders who open more and more trades in an attempt to mitigate mounting losses often end up with an empty trading account. Technical analysis helps in this regard in part because it is oriented towards objective numerical data and, when combined with the right tools, can bring true objectivity to trading.
 

Technical vs Fundamental Analysis

While technical analysis focuses on historical data from the markets to make predictions about possible future developments, fundamental analysis focuses on various financial, economic, and business reports, as well as current geopolitical events and even the weather. Fundamental analysis takes a more holistic approach to markets. It examines so-called fundamental factors and indicators. These influence the possible future price of traded assets.

The economic calendar is an essential tool for fundamental traders. It shows chronologically ordered events (fundamentals) that may have a certain impact on the markets.

So if you are trading oil, you will find the weather mentioned above among the fundamental indicators (seasonal hurricanes in the US tend to damage the oil wells there, which then translates into the price of US WTI crude oil). Fundamental analysis is a more advanced tool that most traders come to gradually.
 
For a beginning trader who wants to specialize in technical analysis, it pays to follow fundamentals to the extent that he or she knows when, for example, central bank meetings or other major market events are about to occur, during which markets can be highly unpredictable.
 

What technical analysis tracks in charts

Trends

This is the longer-term direction of movement of a particular instrument or market. This can be either upward (bullish) or downward (bearish). We can recognize rising trends by the price on the chart reaching a series of higher highs and lower lows. One of the most basic lessons of trading is that the trend is your friend. This is because successfully identifying the emergence of a trend and then trading it is the goal of perhaps every trader.  The principle is to always trade in the direction of the trend.
 

_{Chart 1: Example of a sharp uptrend, sideways trend, and sell-off on the EURUSD pair}

 

 

S/R zones

In full, support/resistance zones are significant price levels on the price chart where the price is expected to react in a certain way. For support zones or levels (a zone contains a larger range of prices, a level is a specific price), a falling chart usually tends to stall and then usually bounce. Sometimes, however, a breakout occurs. Resistance zones/levels, on the other hand, tend to slow or reverse a falling price.
 
S/R zones are a very useful tool for traders as they help them to identify suitable places to enter the market, i.e. open a trading position. The formation of S/R zones depends to a high degree on the psychology of the market and the distribution of forces between sellers and buyers.
 

^{Chart 2: Example of S/R zones on the EURUSD currency pair}
 

Candlestick formations

Trading platforms, through which traders watch charts and then execute trades, allow charts to be displayed in several different ways. One of the most common ones, however, is the so-called candlestick chart. This shows the price in the form of candles, where each candle represents the movement of the price of an instrument per unit of time (on a 30-minute chart, 1 candle will correspond to the price movement over 30 minutes, etc.).
 
Depending on the color of the candle or the size of its body or wick, traders can then determine whether the market was dominated by sellers or buyers over a period of time, what the maximum and minimum price of the instrument was, or what the distance was between the opening and closing price.
 
The candles form so-called candle formations. A candle formation is a price movement that is expressed graphically by candles, on the basis of which the future development can be predicted with a certain probability.  Some formations are formed by one candle, some by two or more candles. Candle formations can be reversal formations, i.e. they signal a reversal of the trend, or continuous formations, where they will indicate a continuation of the trend.  There are many formations and below you will find at least a few of them.

Price Action - an integral part of technical analysis

Price action works primarily with trend lines, S/R zones and candle formations. This is a very popular discipline within technical analysis. Price action focuses purely on the price of the instrument being traded and the patterns (or patterns) that the price - displayed by various chart types - forms. Thus, traders using price action trading strategies do not use any supporting programs or technical indicators. For this reason, price action is traded only from a clean chart.
 
Price action, like technical analysis, can be used for any type of market and is an excellent tool, especially when combined with other technical analysis tools, which we will now discuss.
 

Technical analysis tools

Although technical analysis can only be traded from a clean chart using price action, a large number of traders like to base their decisions on technical analysis tools. These are mathematical and statistical tools that use historical prices, volumes, and other market information. Technical analysis tools visualize the data into a price chart, which can help experienced traders get a better view of market trends or important S/R levels, and thus better time their entry into the market.
 
Technical analysis tools include countless types of indicators, oscillators, and other models, we'll briefly mention these 4 today:
 

• Moving Averages
• MACD (Moving Average Convergence Divergence)
• RSI (Relative Strength Index)
• Fibonacci Retracement
   

Moving averages

One of the most commonly used technical analysis indicators. It is used to "smooth" the price of an instrument - it averages prices over the last X periods. In the image below, you can see that while the price shown by the line chart (black) is choppy, the green moving average shows it more clearly. Moving averages can be arithmetic (simple) and exponential.

MACD

RSI (Relative Strength Index)

Fibonacci retracement

Key terms