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A solid trading strategy sits at the core of all (or at least most) successful trades. This is typically a culmination of proper fundamental and technical analysis as well as prudent risk management. Sure, you can get away with a few impulsive trades, but if you’re gunning for success in the long run, then comprehensive technical analysis is an absolute must.
Technical analysis is a framework for predicting price movements using various tools and market statistics. Traders use this framework to single out lucrative market openings and execute profitable trades. Combining technical analysis with the right trading psychology and risk management can do wonders for your trading career.
Read on to learn everything you need to know about technical analysis, including what is technical analysis, how to use it, and the most effective technical indicators.
In This Guide
What Is Technical Analysis?
The exact definition of technical analysis is murky. Some consider it a collection of tools, while others consider it a trading approach, but the underlying principle is the same. Technical analysis uses past market statistics and historical price charts to assess an asset’s price and predict price movements.
It hinges on the concept that traders can use price movement patterns to predict price action with considerable accuracy. Technical analysis is grounded on a handful of key principles. Below are some of the most notable ones:
- History repeats itself: Human nature and market dynamics are intertwined, and past patterns will occur again in the future.
- The crowd acts as a unit: Different entities in a market act as a collective, and their behavior and actions result in predictable trends and movements.
- Nothing is certain: Financial markets are random and unpredictable, so technical analysis is based on probabilities, not absolutes.
- Market efficiency: The market alone speaks volumes about publicly available information, watering down the utility of fundamental analysis.
- Recursive structures: Financial markets are recursive, where small fractals directly correlate with larger ones.
To conduct technical analysis, traders must picture price movements, and that’s where charts come in. Charts present an easy way to visualize current and past price movements. They use the information from the charts and analysis tools to spot recurring trends that are useful for identifying ideal trading opportunities.
Traders’ collective use of technical analysis is self-fulfilling in that they identify these patterns, execute orders, and self-reinforce price action. However, this is an oversimplification. In practice, it’s much more challenging and quite intricate. Moreover, although technical analysis is a figure-based concept, it’s also subjective and somewhat depends on the trader’s experience and intuition.
Time frames are also a crucial aspect of technical analysis since price movements are a function of time. The time frame ranges vary depending on the broker but are usually from one-minute to yearly intervals. That said, Your choice of time frame depends on your trading style and strategy.
There is no single best time frame(s). When starting out, try different time frames to get a firm idea of how the market moves and understand its structure. Still, it’s worth noting that brokers don’t restrict traders to one or a few time frames. Traders can change time frames on their charts whenever they see fit.
How to Use Technical Analysis in Your Strategy
Admittedly, trading technical analysis is far from a walk in the park, especially for novice traders. The good news is that most of the concepts are related, and it’s easy to get the hang of it with a bit of practice and consistent trading. Using technical analysis effectively will take your trading to the next level and improve your chances of profitable trades.
Do the following to fit technical analysis into your trading strategy:
Understand the Trend
Identify Support and Resistance Zones (S/R Zones)
Find Your Entry and Exit Points
Manage Your Risk
Trend describes the overall direction in which the price of an asset moves. There are three main types of trends in asset trading:
- Uptrend: The price shows an upward trajectory
- Downtrend: The asset’s price keeps receding with time
- Intermediate/sideways trends: The price of the financial instrument remains fairly constant with only minor up and down movements
To incorporate technical analysis into your strategy, you must first understand the market’s general direction/trend. Only then can you decide whether to follow or go against the trend. Remember that each choice has its own implications and can result in either a loss or profit, depending on market conditions.
For instance, in the most basic trend-following trading style, traders will buy (go long) during an up-trend and sell (go short) during a downtrend. Technical analysis will help predict how the market moves so you can make a more informed decision on whether to buy or sell the currency.
With the trend on lock, the next step is to draw support and resistance levels. Support levels occur when the downward movement of an asset price slows down and starts showing upward movement. The opposite is true about resistance levels: an uptrend slows and either stagnates or starts descending.
Traders draw these horizontal lines on support and resistance areas to identify likely trend reversals. Support and resistance are useful in technical analysis and trading because they:
- Help identify opportune entry and exit points
- Guide traders in setting ideal take-profit and stop-loss orders
- Reflect the general market sentiment
Still, it’s worth noting that the price doesn’t always change direction at the support and resistance levels. Sometimes, the price breaks out, meaning it crosses the support or resistance levels. This means the price keeps going down below the support level or up above the resistance level.
Successful trading boils down to finding timely entry and exit points. If you’re new to trading, an entry point is the price at which you execute your trade, and an exit point is where you close your market position.
Support and resistance levels are great for guiding traders on favorable entry and exit points, but technical traders can leverage various tools to do the same. Technical indicators like Relative Strength Indicators (RSI) and Bollinger bands, for instance, help you establish whether there’s enough momentum behind price movement for more calculated market entries and exits.
Remember that technical indicators don’t guarantee profitable trades but only show how the price will likely move. Plus, knowing how to use these indicators effectively requires plenty of practice. Professional traders use multiple indicators to inform their trades and make significant profits.
While you can make a huge killing with trading, the possibility of losing just as much money isn’t far-fetched. Sure, technical analysis can help you trade better, but this doesn’t mean you should throw risk management out of the window. Besides knowing how to use technical analysis in your strategy, you should also manage risk effectively.
The first aspect of managing risk is sizing your position accordingly. Only allocate an amount you’re ready to lose in any trade. Next, identify a reasonable risk-to-reward ratio. This is how much you can earn from every unit asset you risk on a trade. The key word here is “reasonable.” An overly high risk-reward ratio may cost you if the market doesn’t favor you.
A great approach to risk management is using an Average True Range (ATR) indicator. This nifty tool shows an asset’s price variation over a specific period. For example, if you set your stop-loss at 1 ATR for a one-week time frame away from your entry point, It means you’ll close your position if the market moves against you by an amount equal to the highest or lowest price over that timeframe, depending on whether you went short or long, respectively.
Fundamental vs Technical Analysis
Earlier, we mentioned that fundamental and technical analysis were the backbone of successful trades. However, it seems that most traders put more emphasis on the latter than the former. This begs the question, what’s the difference between fundamental and technical analysis, and is one better than the other? Let’s have a brief look at both of them.
Fundamental Analysis
Fundamental analysis studies the intrinsic value (perceived value) of an asset. An asset’s intrinsic value describes its perceived value based on factors like its:
- Financial health
- Growth potential
- Market share
- Leverage
This intrinsic value is not the same as market value – which describes what market participants are willing to pay for the asset. Instead, it’s what the asset is supposedly worth and gives a benchmark for assessing the market value. Fundamental analysis is all-encompassing, examining aspects like an asset’s market condition, financial liability, public relations, etc.
Technical Analysis
Technical analysis, on the other hand, focuses on the current market value and is grounded on figures. Traders focus on this type of analysis since fundamental analysis and perceived value are among the factors incorporated into technical analysis. Remember, price movements in charts embody publicly available information, including an asset’s intrinsic value.
Technical Analysis Indicators
Traders can opt for several technical analysis indicators to amplify their trades. Some of the most technical analysis indicators include:
Relative Strength Index (RSI)
Moving Average Convergence Divergence (MACD)
Average Directional Index (ADX)
Bollinger Bands
Market sentiment can sometimes lead to the overbuying or overselling of assets, leading to rapid price fluctuations. The RSI measures an asset’s recent price changes, specifically how fast and how much the price changes. RSI extremes (high or low) indicate price volatility and likely price reversal.
The MACD indicator helps you establish the direction of the market trend. It consists of an MCD and signal line. The signal line shows the general market direction, while the MACD line is the difference between two moving averages. Combined, the two show trend momentum and are great for helping traders establish propitious entry and exit points.
Another excellent indicator for measuring trend momentum is the Average Direction Index. This is an easy-to-use indicator ideal for beginners. An ADX above 40 shows a high trend momentum, while an ADX below 20 shows low momentum and the likelihood of a sideways trend.
Bollinger Bands complement ADXs, giving additional insight into market volatility and potential price levels. While ADX helps gauge the strength of a trend, Bollinger Bands indicate the price’s relative position within a volatility envelope. When the ADX line approaches the upper Bollinger Band, the current trend will likely persist. Conversely, when it approaches the lower band, the market is weakening and likely to stagnate.
FAQs
Does technical analysis work?
Yes, technical analysis works for the most part, but its effectiveness largely depends on the traders. Traders who use the right technical analysis indicators and exercise proper risk management are likely to reap big. On the flip side, traders who don’t use indicators properly and have unsound risk management strategies will make losses.
Which is the best technical indicator for trading?
There is no “best” technical indicator for trading because trading styles and strategies vary. Explore different indicators and find one that suits your strategy for profitable trades. Some excellent indicators to try include RSI, MACD, Bollinger bands, and ATR, to name a few.
What is the most important thing in technical analysis?
While some would argue that finding the right technical analysis tools is the most important thing in technical analysis, this is far from the truth. Rather, the most important thing in technical analysis is understanding how the market works (market structure) and technical analysis basics. We’re talking about everything from market trends to behavior patterns.
What are the methods for technology (technical??) analysis?
There are no set-in-stone methods for technical analysis. That’s because traders approach technical analysis differently. For instance, some traders focus on monitoring support and resistance levels, while others use momentum indicators to gauge the strength of a trend. Regardless, it’s important to establish a technical analysis formula that resonates with your trading style. You can always borrow a leaf from other traders and see what works for them.
Conclusion
While there’s no denying the technical aspect of technical analysis, it’s absolutely vital for success in asset trading. Beginners should take the time to understand how technical analysis fits into the grand scheme of things before they can incorporate it into their strategies. Successful trading combines technical and fundamental analysis with proper risk management and discipline. Do this conscientiously, and you’ll be set for success in asset trading.
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