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What is Technical analysis? Which trading indicators are most useful?

What is Technical analysis? Which trading indicators are most useful?

Technical analysis is the study and use of price information on the charts to determine the future price movement of a financial asset.

Technical analysis has three premises:

  • a) Market action discounts everything
  • b) Prices move in trends
  • c) History repeats itself

The market discounts everything because all factors that can possibly affect price are captured in the price. Price is therefore a function of demand and supply dynamics, and this explains why demand will be generated by increased buying (due to fundamentally strength), or supply excess will occur due to increased selling (due to fundamental weakness). Price also factors in the herd effect: accumulation when an uptrend has been going on for some time, or panic selling when prices have been falling.

Markets move in trends (up, down or sideways), and will keep moving in a defined trend until an external force causes that trend to change. This is more like Newton’s first law of motion, which is a natural law. So traders will more likely follow a trend, until a factor emerges that causes them to change their sentiment.

History also tends to repeat itself. Why does history repeat itself? This is principally due to human psychology at work in the markets. Human reaction to certain events does not change. If traders see that a descending triangle has led to a fall in prices in the past, they will naturally sell once they see the same pattern on the charts.

What Does Technical Analysis Entail?

Technical analysis studies price charts to determine future price movement. Various methods are used to pull this information. You can identify chart patterns, or patterns formed by candlesticks/bars. These are methods that involve the use of price action. You may also use tools and indicators to get the information you seek. Technical analysis is vast and it involves some level of training to be able to use it. The beauty of technical analysis is that it can be used on all traded financial assets. The outcome of a symmetrical triangle in a gold chart is just the same as you would get on a US stock. This is unlike fundamental analysis, where assets do not all respond to the same fundamentals. The fundamental factors that move stock prices are not the same as what moves crude oil prices.

Common Methods of Technical Analysis

Technical analysis aims to identify the prevailing trends in the market. The trend can be a major trend, intermediate trend or minor trend, and these can occur on a short-term, medium-term or long-term basis.

In identifying the trend, two main pathways are used to achieve this. These are:

  • a) Through the use of price action (candlesticks, chart patterns, support/resistance).
  • b) Via indicators.

Price action does not use indicators, but rather relies on what price can be seen to be doing on the charts. Therefore, price action strategies involve the use of chart patterns and candlestick patterns, all with bearish and bullish variants. It also involves the use of various tools that can identify support and resistance levels. Common chart patterns are triangles, wedges, flags/pennants, tops/bottom patterns:

– Triangles: ascending, descending, symmetrical.
– Wedges: rising and falling.
– Bottoms: double top, triple top, rounding bottom, inverse head and shoulders, saucer and lid, cup and handle.
– Tops: head and shoulders, double top, triple top, rounding top.

Candlestick patterns commonly use a combination of two, three or four (and sometimes five) candlesticks to identify what traders on both sides are doing in the market. Each candlestick pattern usually tells a story. Here are some common candlestick patterns:

– Bearish candlestick patterns: three black crows, evening star, evening doji star, bearish engulfing, bearish harami.
– Bullish candlestick patterns: bullish engulfing, bullish harami, three white soldiers, morning star, morning doji star, piercing pattern.

Commonly used support-resistance tools are:

– Trendlines
– Channels
– Tools based on the Fibonacci numbers (Fibonacci retracement and extension tool, Gann fans, Gartley patterns, etc)

There are times when use of price action may not suffice, and it may be pertinent at this stage to add technical indicators to the mix. Indicators may be trend indicators, momentum indicators, volume indicators and custom indicators. Some indicators provide a signal before price moves (leading indicators), while others tend to provide signals as the market is already in motion (lagging signals).

The snag with indicators is that they are subject to individual interpretation, so a trader who cannot interpret the signals generated by indicators, or who interprets the signals wrongly, may not get the desired outcomes. Correct use of indicators is therefore a must if they are to work properly. - Trend indicators: moving average (simple, exponential, weighted), parabolic SAR, envelopes, average directional movement. - Momentum indicators (oscillators): Stochastics, moving average convergence divergence (MACD), DeMarker, etc. - Volume indicators: Volume bars, On Balance Volume, etc.

What are the Best Indicators to Use?

With technical analysis, it is difficult to point out which indicators are really the best. All indicators will typically work as the trader wants. It is therefore not in how inherently good or bad an indicator is, but rather a function of application. A good indicator used wrongly by a trader will not produce the desired results. Be that as it may, it must be said that indicators and tools that can detect support and resistance are about the best friends you can have as a trader who uses technical analysis. The markets tend to respect support and resistance levels, and these can be used for trade entries and exits.

As such, you will find usefulness with the following indicators/tools:

  • a) Line tool (used to plot trendlines across price highs and lows, thus forming resistance and support lines).
  • b) Fibonacci retracement and extension tool: This is used for retracement-based entries and exits, taking into account the unquestionable fact that trends do not move in a straight line but tend to fluctuate.
  • c) Pivot point calculators, which calculate pivot points on a daily basis and therefore identifies daily support and resistance areas.

It is not just support and resistance that a technical analyst must consider. Prices move in trends, therefore you have to know how to trade in a trend (uptrend or downtrend), or how to trade when the market is moving sideways or consolidating. For these situations, you will need to know how to use the following indicators:

  • a) Trend indicators > Moving average.
  • b) Momentum indicators which are also useful for range-trading > oscillators such as Relative Strength Index, MACD, Stochastics, Commodity Channel Index (CCI).

Volume is also a key determinant of a trend. Information as simple as knowing whether volume is heavier on the buying side or on the selling side, can make the difference between success and failure in analyzing an asset technically. So volume indicators to use are:

  • a) Regular volume bars.
  • b) On Balance Volume (OBV) > a volume indicator that also works as an oscillator.

Cautious Use of Technical Analysis

Technical analysis must be used in conjunction with fundamental analysis. This is because trends are formed by the news. The market players who drive price will quickly respond to a change in interest rates, and this will take pre-eminence over any patterns formed on a chart.

A common market mantra is: trigger fundamentally, enter technically. Therefore, technical analysis should only be used to identify entry and exit points in a trade, following the direction that the news points to.