Technical analysis forecasts the movements of stocks based on charts. What is this magical thing called technical analysis and does it really work?
In this article I am going to explain you what technical analysis is and how you can profit using it as trader or investor.
Difference between technical analysis and fundamental analysis
As trader you want to profit as much as possible by buying and selling at the right time. To do this, you have to correctly predict the price of a stock in the (near) future, so that you know the best entry and exit points.
But how can you predict these market movements? As trader you have two answers to this question:
1. Fundamental Analysis
2. Technical Analysis
Fundamental analysis looks at the background information of a financial instrument or asset of which you want to predict the price of. If, for example, you want to buy Apple stocks, you check the latest iPhone model sales. This is a good example of fundamental analysis.
You also scan the news for any upcoming releases or possible mergers and acquisitions. This way you gain a positive or negative view of the company and trade or invest accordingly. You either buy (going long) or sell (going short).
Technical analysts don’t even look at this data. They look at very different things…
What is technical analysis?
Technical analysis is using price movements in the recent past to predict price movements in the near future.
Technical analysis is everything except water proof and it’s never 100% accurate. It is ment as a tool to make an educated guess and as long as you’re more often right than wrong, you profit, especially in the case with binary or digital options.
Technical analysis is no exact science!
Technical analysis software
Now that you know you have to inspect the charts during technical analysis, it might be good to know that there’s free software out there that can help you with this.
TradingView is considerated world’s best free charting tool and is available to download on both Windows and Mac.
Most technical analysis software allows you to set the chart in candlesticks mode. This type of price-action display originates from Japan and has it’s name due to the fact that the charts look like candlesticks, with a body and a wick.
These candles show the price movement over a certain time frame and come in three colors:
1. Rising/bullish candle, green
2. Falling/bearish candle, red
3. No change candle, black or white
In the case of a rising candle, the bottom side of the body is the opening price and the upper side of the body the closing price. In the case of a falling candle, the upper side of the body is the opening price and the bottom side of the body the closing price.
If you set your chart on 5 minutes, every candle represents 5 minutes. If you set your chart on 1 day, every chart resembles 24 hours.
The possible wicks on the upper or bottom side of the candle, shows us what the highest and lowest price were within the chosen timeframe.
Candles tell you a lot about the price movements of a stock other asset and indicates where it is moving next.
So, the first step in doing technical analysis is looking at the candlesticks.
Once you know how to do candlestick analysis, the next step is the recoqnition of trends. Whilst doing this, you question yourself if the price action is moving upwards, downwards or horizontal.
The answer to this question contributes to your technical analysis and about what the price might do in the near future.
Support and Resistance
Another important factor during technical analysis is identifying support and resistance levels, in short support and resistance. These levels can be the upper or lower side of a trend, but the strongest levels of support and resistance can be found at horizontal levels.
In short this means that these are points at a chart of which you can clearly see the price bounces.
Hopefully, you understand that support and resistance are inevitable when performing technical analysis and what the price of a certain asset is going to be in the near future.
In my own trading strategy support and resistance levels play a key part.
Last, but not least, traders can use hundreds of indicators. These indicators calculate price data from the past and fire off a singal about what the price could do in the near future.
In most cases, multiple indicators are being used to create ‘confluence‘. This means that a traders buys or sells when multiple signals point in the same direction.
The most popular indicators are:
– Moving Averages
– Bollinger bands
Technical Analysis within a Trading Strategy
Technical analysis is being used as foundation for a trading strategy. I say basic, because a strategy consists of way more than just a price flinging of a support level.
You could trade breakouts or reversals based on support and resistance, but apart from that you must also maintain risk management. Ideally, you see technical analysis as part of your trading strategy.
Testing out Technical Analysis
The best thing about technical analysis is that you can test to see if it works. Once you apply the rules and buy or sell according to your trading strategy, then you can swipe the chart to the left and replay history per candle.
Enter and exit the market according to the rules within your trading strategy and follow the signals the chart is giving you. After a while you can see exactly if your strategy is working or not.
Pros and Cons of Technical Analysis
If you’re reading this all, then technical analysis of course looks great. Drawing a few lines on a chart and the money starts pouring in, right? Unfortunately it doesn’t work like this. Technical analysis can help you tremendously as a trader but it has it cons.
Like I told you before, technical analysis isn’t an exact science and certain things just stop working in certain market conditions.
Technical analysis is rather subjective as a whole, because every trader interprets his or her charts different. What’s a valid signal for one trader, isn’t for the other.
Most indicators are what professional traders call ‘lagging indicators’. They only fire off a signal when pricemovement is already happening. This greatly increases your risk during the moment of entry. This is also the reason I don’t use indicators myself.
There is a huge danger in using to many indicators. They will contradict each other and you will receive the wrong trading signals.
Performing Technical Analysis
Whatever trading strategy you choose to use and however you decide to perform your technical analysis, always practice first. Every self respecting broker offers a free demo account with which you can practice trading with virtual of demo money.