Basics
of Technical Analysis
Technical
analysis can be used on any freely traded security in the global market and is
used on a wide range of financial instruments, such as equities, bonds,
commodities, currencies, and futures. However, typically, technical analysis works
best in markets where trading is frequent and there are many buyers and
sellers. So, it's not as useful for securities that aren't traded often,
because even a small trade can cause big price changes.
‘What’ is more important than the ‘why’ in technical analysis:
In
technical analysis, the "what" refers to the actual price movements
and patterns observed on charts, while the "why" involves the
underlying reasons or fundamental factors driving those price movements. Some
proponents of technical analysis argue that focusing on the "what" is
more important than the "why" for several reasons.
Technical
analysis has main principles and assumptions:
The market
discounts everything,
All relevant
information, including past trading data, fundamental factors, and market
psychology, is already reflected in the asset's price. The main objective of
technical analysts is to analyze price movements and patterns in order to make
trading decisions.
Prices exhibit trends and countertrends in their movements
Prices
exhibit trends and countertrends in their movements, dynamic interplay between
buying and selling pressure in the market. Trends represent sustained
directional movements, whether upward (bullish) or downward (bearish) or Neutral(sideways),
while countertrends denote temporary reversals against the prevailing trend. Understanding
these patterns is vital for traders, as it enables them to identify potential
entry and exit points, manage risk, and take advantage of market opportunities.
The price
action is repetitive, with certain patterns repeating.
Another fundamental assumption of
technical analysis is that historical price movements tend to repeat themselves
in the future. Patterns and behaviors observed in the past are expected to
recur under similar market conditions. Traders leverage this principle to
identify recurring patterns and anticipate potential price movements, providing
them with valuable insights for making informed trading decisions.
Volume Confirms Price Trends
The relationship between trading volume and price movements.
When prices rise or fall accompanied by high trading volume, it suggests strong
market conviction, validating the trend's strength. Conversely, if price
movements occur with low volume, it may indicate weak market participation and
potential trend reversals. By analyzing volume alongside price action, traders
gain insights into the reliability of price trends, aiding in decision-making
and risk management.
The foundation of technical analysis
is that market behavior is heavily influenced by human psychology, with 80% of
its dynamics being psychological and 20% being logical and rational. Whereas
Fundamental analysis places 80% of market behaviour on logical factors and only
20% on psychology. However, both
approaches believe that current prices accurately represent what investors
collectively believe about a security's value. Technical analysis looks at how
prices and trading volumes change over time to understand whether more people
want to buy or sell a particular asset, helping to predict where prices might
go next.
