Technical analysis is how traders use statistics generated from market activity to analyze securities. Unlike fundamental analysis, which attempts to evaluate a security’s intrinsic value, technical analysis focuses on charts and patterns to identify trends and make predictions.
Here is an overview of some of the main tools and techniques used in technical analysis:
Chart Patterns
Certain patterns in price charts can signal potential opportunities to traders. Common chart patterns include head and shoulders, triangles, flags, and cup and handles. These patterns reflect shifts in supply and demand and often indicate trend reversals or continuations. Traders usually enter or exit positions when prices break out of these patterns.
You can utilize advanced charting tools on platforms like TradingView.
Candlestick Charts
Candlestick charts display price action using candlesticks that have different shapes based on the relationship between the open, high, low, and closing prices during a period. Certain candlestick patterns like Doji, Hammer, and Engulfing patterns indicate potential reversals. Traders use these patterns to identify entry and exit points.
Some of the most common candlestick patterns include:
- Doji – This pattern appears when the open and close are nearly equal, creating a cross-like appearance. It signals market indecision and potential reversal.
- Hammer – A hammer has a long lower wick and small real body at the top of the candle, indicating that buyers overpowered sellers and drove prices up after an initial decline. It is a bullish reversal signal after a downtrend.
- Engulfing – An engulfing pattern occurs when the real body of the current candle fully engulfs the real body of the previous candle, reflecting a strong shift in momentum. A bullish engulfing forms when an up candle engulfs a preceding down candle.
- Shooting Star – This shows a long upper wick, little real body, and small lower wick, indicating that buying pressure faded intraday and sellers took over. It is a bearish reversal signal at market tops.
- Piercing Line – In a downtrend, this is an up candle with a long lower wick that closes above the midpoint of the prior down candle, signaling potential bullish reversal.
Traders usually use these and other candlestick patterns in combination with other indicators to better time entries and exits. The psychology and crowd behavior revealed in candlestick patterns can improve trading decisions.
Support and Resistance
Support and resistance levels represent price thresholds where selling or buying pressure prevents the price from moving further down or up. Support occurs when demand is strong enough to prevent the price from falling below a certain level, while resistance happens when supply is abundant enough to keep the price from rising above a level. Watch these levels closely to spot potential breakouts.
Trend Lines
Drawing trend lines connects a series of highs or lows to show the prevailing direction of price movement. Upward sloping trend lines indicate uptrends while downward sloping trend lines signal downtrends. The angle of the trend line illustrates the strength of the trend. Try to buy on pullbacks to upward trend lines and sell near downward-sloping trend lines.
Moving Averages
A moving average smooths out price action by averaging prices over a specified period. The 200-day moving average is a widely followed indicator that traders use to identify long-term trends. A crossover can signal a potential trend change. Moving averages act as dynamic support and resistance levels.
Oscillators
Oscillators like the Relative Strength Index (RSI) and Stochastics evaluate momentum by comparing an asset’s current price to its historical price range. They oscillate between overbought and oversold levels. Readings above 70 or 80 suggest an asset is overbought, while levels below 30 or 20 indicate oversold conditions. Divergences between oscillators and prices can foreshadow trend changes.
Volume
Volume indicates the total number of shares or contracts traded during a specified time period. High volume points to significant interest in an asset while low volume suggests limited interest. Rising volume confirms new trends and falling volume precedes trend reversals. Volume can confirm price breakouts or signal weakness.
Identifying patterns, support and resistance levels, trends, momentum shifts, and volume surges allows traders to time entries and exits. Technical analysis tools identify opportunities and risks that are often not apparent from just looking at closing prices.
However, technical analysis still requires context-based human interpretation to be effective. Indicators derive from past price action and cannot predict changes in fundamentals, earnings, or economic forces. Technical analysis is best used in conjunction with other methods of analysis.
Traders use technical analysis to capitalize on short to medium-term opportunities, but no approach is foolproof, so utilizing stop losses remains key. With practice and experience, technical analysis can help traders better navigate the financial markets. The right mix of chart patterns, indicators, and human judgment can demystify trading decisions and lead to smart, calculated trading.
