Technical analysts use charts and graphs to analyze trends, patterns, and other market data to identify buy and sell signals. The main concept of technical analysis is to analyze historical price and volume data to make predictions about future price movements in financial markets. It is based on the belief that past price and volume patterns can provide insights into potential future trends, allowing traders and analysts to make informed trading decisions. Technical analysis is based on the following basic concepts:
Market Prices Reflect All Available Information
Technical analysts believe that all relevant information, including economic, financial, and psychological factors, is already reflected in the price of a financial instrument. This idea is known as the "Efficient Market Hypothesis" (EMH). Therefore, technical analysis focuses on analyzing price movements and patterns rather than trying to predict fundamental factors.
Another core belief of technical analysis is that price movements tend to follow trends. These trends can be categorized as uptrends, downtrends, or sideways (ranges) movements. Technical analysts seek to identify and ride these trends for profit. As a rule, trends are determined through the market structure, through trend lines, or by using trend indicators.
Historical Price Patterns Repeat
Technical analysts believe that historical price patterns, such as chart patterns and candlestick patterns, tend to repeat themselves. By recognizing these patterns, analysts can anticipate potential future price movements.
Support and Resistance Levels
Support levels are price points at which security tends to find buying interest and potentially reverse its downward movement. Resistance levels are price points at which selling interest often emerges, potentially halting an uptrend. These levels help traders set entry and exit points.
Forex market sentiment refers to the general attitude or mood of traders and investors towards a particular currency pair Forex. It reflects the collective opinion and emotions of market participants, which can influence the direction and intensity of price movements. Market sentiment can be bullish (positive), bearish (negative), or neutral (sideways). Traders analyze market sentiment to assess the potential strength or weakness of a currency and make informed trading decisions. The most effective way to gauge market sentiment is usually by looking at open positions for a particular symbol.
Volume is the measure of the number of shares or contracts traded in a given time period. Volume can provide insights into the strength or weakness of a price movement. For example, a significant price move with high volume is considered more reliable than a similar move with low volume. Since the Forex market is a decentralized trading place, i.e. there is no single trading venue like the NYSE for example, the volume indicators here are less informative than on other exchanges. However, since currency pairs quotes are derived from currency futures pricing, Forex traders can use CME exchange volumes to analyze currency pairs on Forex.
Indicators and Oscillators
Technical analysis often employs various indicators and oscillators, such as moving averages, Moving Average Convergence/Divergence (MACD), Relative Strength Index (RSI), and Stochastic Oscillators, to provide additional information and confirm or contradict price signals.
Technical analysts use chart patterns (e.g., head and shoulders, flags, triangles, wedges) and candlestick patterns to identify potential price reversals or continuations. These patterns are formed by historical price data and are used to make trading decisions.
Technical analysis can be applied to various time frames, from intraday charts (minutes or hours) to longer-term charts (daily, weekly, or monthly). Traders choose time frames based on their trading objectives and strategies. It is always recommended to use 2-3 time frames for a more accurate analysis for a better understanding of what is going on.
Psychology of Market Participants
Technical analysis considers the emotions and behavior of market participants. It assumes that fear and greed drive market movements and that these emotions can be seen in price patterns and trends.
Technical analysts place a strong emphasis on risk management. This includes setting stop-loss orders to limit potential losses and adhering to a trading plan that defines entry and exit criteria.
It's important to note that technical analysis is not without its critics, and there is ongoing debate about its effectiveness. Some argue that it can be self-fulfilling, as many traders use the same patterns and indicators, while others believe that fundamental analysis, which focuses on economics, is a more reliable approach. In practice, many traders and investors use a combination of technical and fundamental analysis to make their decisions, and they adapt their strategies to suit their individual preferences and risk tolerances.