April 7

What Is Technical Analysis?

Last Updated on 7 April, 2022 by Samuelsson

Whether you trace the origin to the 19th century American Charles Dow, who created the DJIA Index, or the 18th century Japanese Homma Munehisa, who invented the candlestick chart, technical analysis has got a rich history. And traders will continue to use it in their quest to get an edge in the market.

Technical analysis is an analysis method where traders analyze recurrent patterns in the price of a security, in order to know when to enter and exit the markets. Technical analysis covers a broad spectrum of methods, including commonly known methods like technical trading indicators, like the RSI and ADX, and chart patterns, like wedges and triangles. 

Technical analysts use technical analysis to track human psychology in the market and how it affects the price of a security. Owing to the importance of technical analysis in trading, we have created this comprehensive guide to teach you all you need to know about the subject.

In this guide, you will learn the following:

  • What technical analysis is, how it is used, the common criticisms, and why it works
  • How technical analysis is different from fundamental analysis
  • Price action trading
  • Indicator trading
  • Leading and lagging indicators
  • Common types of chart
  • Seasonality in the market and how to take advantage of it
  • Common technical trading strategies
  • How to use volume in trading
  • How to make use of the volatility index in trading
  • Technical analysis tips

Since the guide is so long, we have made it easy for you to jump to your preferred sections within the article. Just click the toggle bar that exists under every major heading. Like the one below:

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And here comes the table of Contents:

What Is Technical Analysis?

Technical analysis is a method of analyzing a financial asset, such as a stock, commodity, currency pair, options, or futures, to identify trading opportunities. It is used to predict where the price of an asset will go in the future, based on what is happening in the market now and what has happened in the past. Followers of this method use various charts and market data to study the activities of investors in the market in order to forecast future price movements.

Simply put, technical analysis is a way of analyzing a market by using charts to study market action. The term market action implies all the metrics used to indicate the activity in the market, such as price, volume, and open interest. Open interest is used in the options and futures market to denote the total number of outstanding contracts that are yet to be settled.

Technical analysis is based on the idea that all you need to analyze a security — and make a fairly accurate prediction of the future price of that security — is the historical trading activity in that security, expressed in price, volume, and open interest (where applicable).

Any security that has historical market data can be analyzed with technical analysis methods. So technical analysis can be used on stocks, exchange-traded funds, bonds, currencies, futures, options, commodities, and even the volatility index.

The Importance of Price Action for Technical Traders

Unlike a fundamental analyst, who tries to evaluate a security’s intrinsic value, a typical technical trader would only study the chart to identify price patterns and changes in volume. Technical analysts believe that the price of the security and the volume transacted are the most reliable predictors of future price direction. They believe that the price and volume data can show the imbalance in supply and demand of the security, which is what determines the direction of price movement in the future.

Some technical traders (pure technical traders) make their trading decisions solely on their analysis of chart patterns and volume, without any consideration of fundamental factors. However, many technical traders still consider fundamental factors when buying or selling a security — at the very least, they stay away from the market during major news releases.

The official group that trains and certify technical analysts is the Market Technicians Association (MTA). Although any trader can learn technical analysis on his own, advanced technical analysts are examined and awarded with the Chartered Market Technicians (CMT) certification by the MTA.

Brief History of Technical Analysis

In the Western world, it is believed that technical analysis was first introduced by Charles Dow when he teamed up with his friend in 1896 to create the equity market index named after their names — Dow Jones Industrial Average. Through his regular stock market editorials in The Wall Street Journal (a financial publication he founded), Charles Dow also laid the early foundation of what later became known as the Dow Theory — the basis of technical analysis.

However, many aspects of technical analysis have been in existence in Japan more than a century before Charles Dow was born. The Japanese believe that Homma Munehisa invented technical analysis when he developed a method to track the price of rice coupons in the 18th century — what would later become known as the candlestick chart.

Read more about the history of technical analysis here.

Uses of Technical Analysis

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Technical traders have different ways of using technical analysis, and no two traders have the same approach to technical analysis, even the certified ones. So both the analysis and how it is used are quite subjective, as individuals try to modify several aspects to suit their perceptions and personalities.

However, despite the variations in methods and styles, there are some common grounds. Certain things are generally accepted, although individual traders may use different technical tools to achieve them. For the most part, technical traders use technical analysis to:

  • Identify the price trend
  • Mark important price levels
  • Know when to enter a trade
  • Estimate profit targets
  • Place stop losses
  • Decide when to exit a trade

Price Trend

Technical analysis can be used to identify, firstly, if the price is in a trend or just moving sideways. And if in a trend, it can show the direction. To know if the price is in a trend or not, traders check their price charts to see if the highs and lows of price swings remain at the same level or are moving in a particular direction.

If the price swings are moving up, with higher highs and lower lows, the price is said to be in an uptrend. Conversely, if the swings are moving lower, with lower lows and lower highs, the price is in a downtrend. Technical traders would often attach a trendline on the successive swing highs or swing lows to help them easily identify the direction through the slope of the trendline.

Alternatively, some traders use technical indicators to decipher the trend direction. The most common indicator for this purpose is the moving average indicator. A flat moving average line indicates sideways movement. If the line is sloping upwards, the price is in an upward trend, and if it’s sloping downwards, the price is trending downwards.

Trend in Technical Analysis
Trend in Technical Analysis

Important Price Levels

There certain levels where the price tends to get to and reverse or temporarily pause. They are often called support (if they are below the price) and resistance (if they are above the price) levels. Traders use technical analysis to identify such levels in advance so as to take advantage of the potential price reaction there.

Technical traders often look at the previous swing highs and lows to map out the resistance and support levels. Some may use certain technical tools, such as the pivot lines and Fibonacci retracement and extension or expansion tools, to identify potential levels, while others use indicators to do the same. Indicator users mostly use long-period moving averages, such as the 200-day moving average, as potential a support or resistance level, depending on where the price is in reference to it.

Below is an example of how a previous high acted as a resistance level!

Resistance Level
Resistance Level

If you want to learn more about how to use support and resistance in your trading, be sure to check our article on support and resistance!

Trade Entry

Another important use of technical analysis is to determine when to enter a trade. Some traders, who predominantly use fundamental analysis to evaluate a security, still make reference to technical analysis to identify the best possible time to enter a trade.

For pure technical traders, however, technical analysis is used to define what constitutes a tradable opportunity — a trade setup. In addition to using the analysis to guess the future direction of price movements, they also use it to develop some rules about when to enter (or not enter) a trade.

For technical traders, trading becomes a rule-based game, where a trade is entered only when all the criteria for a trade setup is met. If the criteria are not met, the trader stays on the sideline and wait for the setup to complete.

So technical analysis simplifies the process of entering a trade, and this has led to the creation of many software programs that execute the trades or, at the very least, alert the trader when the setup is complete.

Profit Targets

Profit targets simply are levels where you decide to exit a trade and take profit.

There are many ways that technical analysis can assist you in finding the appropriate profit target level. For example, you could use the Average True Range indicator to place the profit target at a distance from the entry that accounts for market volatility. Another example is to use support or resistance levels and exit a trade once the market hits one of them, depending on if you are long or short.

When it comes to chart patterns,  they have often have a measurable projected price movement. For instance, when the price breaks out of a triangle pattern, it is expected to make a move that is approximately the size of the base of the triangle.

Below you see how a breakout from a triangle leads to a move upwards that measures the same distance as the base of the triangle.

Triangle Profit Target
Triangle Profit Target

Similarly, a head and shoulder pattern is expected to move a distance that is equivalent to the size of the head. So a trader may know, beforehand, how far the price will move in a particular direction and use it to estimate where to lock in profit and get out of the trade.

However, in our experience typical chart patterns like the ones above simply don’t work. Still, they are worth mentioning, since they are so popular and common among traders!

If you want to learn more about profit targets, be sure to read our guide on how to use a profit target!

Stop Loss

Experienced traders know when to get out of a trade if it’s not going fine, and it is technical analysis that they use to make such calls. The same way it tells when there’s a trade setup, technical analysis can tell when an already-established setup has been invalidated so that the trader, who placed a trade when the setup initially appeared, can get out of the trade with as little loss as possible.

Most commonly, traders use technical analysis to know how far they can allow the price to move against them before they can accept the loss and move on. Technical analysis helps them to establish a level beyond which their trade setup has been made invalid, and this would be the place to place their stop-loss orders.

This level could be beyond an important support or resistance level, a round number, or a long-period moving average.

The image below is an example of a trade, where the stop loss is $20 away from the entry.

Stop Loss Example
Stop Loss Example

Here you can read more about stop losses and how to use them!

Exiting a Trade

Apart from being used to place your protective stop loss, technical analysis is also used for the main exit method. There really is no limit to the conditions that you could use to exit a trade, but here are two simple methods that we use a lot:

  • Time Exit- You simple exit after a certain number of bars or days
  • RSI Exit – for our mean reversion strategies we often use an oversold RSI reading as the exit signal

As you see, these are really simple methods, and often times they work surprisingly well!

Criticisms of Technical Analysis

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Technical analysis is not without some criticisms, just like everything in finance. Although technical analysis has not received as much academic scrutiny as fundamental analysis a lot of questions have been asked about whether previous price data can actually tell anything about the future price direction.

Criticism of Technical Analysis
Criticism of Technical Analysis

Some of the common criticisms of technical analysis are based on the following:

  • The market is efficient
  • Price movements are random
  • Technical analysis is just a self-fulfilling prophesy

Efficient-market hypothesis

Some academic financial experts believe that the market is efficient and reflects all available information about a security, so there’s no way to identify imbalances in pricing from past market data and take advantage of it. This idea of the market is what is referred to as the efficient-market hypothesis.

Fundamental analysts and the proponents of the efficient market idea don’t believe that technical traders can find an edge in the market from analyzing price patterns and volume data. However, this theory presupposes that market participants always act rationally — which can’t be further from the truth.

Random Walk Hypothesis

Another set of economists think price movements are random and cannot be predicted by any price patterns or volume changes. This group argues that history doesn’t repeat itself because if a price pattern is known to work in a particular way, the market participants will act in such a way as to prevent it from working in the future.

But just like the efficient-market theory, the random walk hypothesis doesn’t consider the irrationality of market participants. Most of the market still is random, but there exist recurrent patterns that traders can make use of in their trading. These are what we call Edges.

Self-fulfilling Prophesy

The third criticism is that technical analysis is only a self-fulfilling prophecy when it works. In other words, many traders know the technical patterns and act the same way when the pattern appears, thereby creating a buying or selling wave in response to the pattern.

So the traders effectively fulfill their expectations of the market but may not be able to do that for long. While it may be true that the concerted actions of a large number of traders can move the market, it is simply the market forces — demand and supply — at play.

Why Technical Analysis Works

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Technical Analysis Works!
Technical Analysis Works!

Despite the criticisms, evidence abounds of traders who have made a lot of money using technical analysis methods. The major reason technical analysis works is that it simplifies the process of trading. Technical analysis makes it easy for us to define what constitutes our edge in the market — trading becomes a rule-based game where you create your own rules and play by them.

It is possible to identify and define an edge in the market through technical analysis because:

  • Price moves in trends and can form recognizable patterns
  • History repeats itself
  • Market action discounts everything

Price Moves in Trends and Forms Recognizable Patterns

The first reason we analyze price data is that price can trend in one direction or the other. There are different types of trends, depending on the duration and the timeframe you’re using to analyze the price. Long-term trends can last for several years, and you can analyze it on the monthly and weekly timeframes. Medium-term trends can be appreciated on the daily timeframe, and they tend to last from a few weeks to a few months. Short-term trends last from a few days to a few weeks, and you can analyze them on the 4-hourly and hourly timeframes.

The second reason is that price can form recognizable patterns that can help us identify when a security is likely to move in one direction. There are many small edges (patterns) that go undiscovered by the large masses, that can indicate, for example, an imminent turnaround in the market!

Technical analysis helps us to identify those price pattern directly from the price data or through an indicator. Chart patterns, such as the head and shoulder pattern, are known to occur at trend reversals. Similarly, there are technical indicators like the ADX, which can tell when a new trend is forming — more on these later.

Once again it is worth pointing out that we have not had any success with commonly used chart patterns such as head and shoulder pattern. In fact, we don’t believe in them, but choose to include them just for the sake of completeness!

History Repeats Itself

Market activity has a lot with human psychology, and moreover, humans constitute the market participants. Since humans tend to repeat their actions time and again, those price trends and patterns will keep repeating in the future. Technical analysis shows that if you want to understand what price will do in the future, you need to study what it has done in the past.

Not only do the trends and patterns repeat themselves, but the market also has memory and can remember previous important price levels (support and resistance levels). This is the reason those price levels are respected in the first place. Technical analysis helps you to identify those levels and take advantage of them.

The Market Discounts Everything

Technical analysts believe that all possible factors (fundamental, political, sentiment, climate, natural disaster, terrorism) that can affect the price of a security is already reflected in the market action. So by studying the activity in the market, a trader can identify an imbalance in the demand and supply of the security and profit from it.

Although this premise may appear similar to the efficient-market hypothesis, it doesn’t. In fact, they are miles apart. The technicians’ idea of market action discounting everything acknowledges the fact that market participants can be irrational, and this irrationality creates an imbalance in demand and supply, which is what gives rise to price trends and patterns — the very footprint technical analysis tries to find.

The efficient-market hypothesis, on the other hand, denies this aspect. It believes that the market participants are rational, and there can never be an imbalance in demand and supply, so the market is forever in equilibrium — how wrong they are.

How Technical Analysis Is Different from Fundamental Analysis

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Technical Analysis VS Fundamental Analysis
Technical Analysis VS Fundamental Analysis

Technical analysis and fundamental analysis are the two main approaches to participating in any financial market. While with technical analysis a trader tries to use patterns and changes in the security’s price and volume, to predict the future direction of price, with fundamental analysis, an investor evaluates a security by trying to measure its intrinsic value, using such factors like economic conditions, quality of management, earnings, and revenues.

Fundamental analysis and technical analysis appear to be at the opposite end, and traders often classify themselves as either technicians or fundamentalists. But the truth is, the two approaches overlap. Some fundamental followers have a basic knowledge of technical analysis and use it to time their entry in the market. Similarly, technical traders may have some knowledge of fundamental factors and consider them when making trading decisions.

Having said that, these are some of the key differences between technical and fundamental analysis:

1. Function

The two approaches differ in how they are used: while fundamental analysis is mostly concerned with investing, technical analysis is mainly used for trading. Traders rely on technical patterns to identify opportunities to make quick profits. But investors are more likely to buy and hold an asset, so they tend to use fundamental analysis to look for stocks that suit their style.

2. Time Horizon

Fundamental analysis tends to have a long-term outlook, as fundamental investors often look for stocks that will grow in value over a long time. On the contrary, technical analysis  more often is used to find short-term trades that will yield quick profits, even though they may be quite small. The belief is that these profits can compound to huge amounts over time.

3. Main Goal

The aim of fundamental analysis is to find the intrinsic value of the asset (stock), so it focuses on factors that can be used to estimate that. A fundamental analyst will often start by studying the general condition of the economy, checking things like interest rate, commodity prices, and the political situation of the country.

The fundamentalist will study the financial situation of the company behind the stock by analyzing the quarterly earnings, sales, and revenues and compare them with similar quarters in the preceding year. At this point, the analyst will study the various financial ratios — earnings per share, price to earnings ratio, projected earnings growth, price to book ratio, price to sales ratio, and others. The analyst may even compare them with those of the company’s competitors and the industry’s average. Finally, the analyst will check the quality of the company’s management and its outlook on the long-term profitability of the company.

Technical analysis, on the other hand, aims to identify the right time to enter and exit a trade with profit by analyzing the market action — price action and changes in volume.

4. Ease of Acess to Information

Finding data for Fundamental analysis is more intense and takes more time since all the data needed for the analysis cannot be found in one place — moving from government’s websites for general economic data to the company’s website and then, to the competitors’ website.

On the other hand, the data you need for technical analysis takes less time to find. All the data you need for the analysis is there with you on your screen.

It is important to note that this by no mean suggests that technical analysis is easier! Everybody can analyze the markets technically, but very few will be able to turn their analysis into money!

5. The Rationale

Technicians and fundamental analysts act on somewhat different grounds:

Technicians make money from the fact that imbalances in demand and supply will often create some recognizable trends and patterns which can indicate the next direction of price. Technicians also believe that these patterns repeat themselves, so the analysis of previous patterns can be a profitable adventure.

Fundamental analysts, on the other hand, make money from that even though the price may not agree with the prevailing fundamental realities in the short term, over time, the market will correct itself. Thus, it’s profitable to buy and hold an undervalued stock or a stock with huge growth potentials.

6. Type of trader

Investors and long-term position traders tend to mostly make use of fundamental analysis, while short-term traders like swing traders, day traders, and scalpers make use of technical analysis. However, most of the market participants often use a combination of both.

The Common Types of Trading Charts

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Charts are graphical representations of market activity. Most of the time, charts are used to represent price movements but can also be used to represent volume. Some common charts are time-based, and they include:

  • Candlestick chart
  • Line chart
  • Bar chart
  • Heiken Ashi chart

Others are not time-based, and they include:

  • Tick chart
  • Volume chart
  • Range bar chart
  • Renko chart
  • Point and figure chart
  • Kagi chart
  • Three-line break chart

Let’s now cover all of them!

Candlestick chart

Candlestick
Candlestick

Also called the Japanese candlestick chart, the candlestick chart originated from the 18th-century Japanese rice traders. The chart is color-coded, so the price action can easily be seen. Each candlestick shows details of price movement during a single trading session. A candlestick consists of a body, an upper, and a lower wick, and it clearly shows the:

  • Opening price
  • The highest price
  • Lowest price
  • Closing price

Below you see a candlestick chart where some candlestick patterns have been marked as well! We will have a closer look at candlestick patterns soon! If you can’t wait, we recommend that you have a look at our massive guide to candlestick patterns!

Candlestick Charts
Candlestick Charts

The Benefits of Candlestick Charts

Apart from showing the details of the price movement in each trading session, the candlesticks can take different shapes, which can give clues about future price movements. A few consecutive candlesticks can form patterns that are even more significant than the individual candlestick shapes.

Another interesting benefit is the customizable color-coded bodies which make the chart very visible. So you can easily see when the price gaps.

Bar chart

A bar chart is similar to the candlestick chart, and it is sometimes called the OHLC (open, high, low, and close) bar chart because each bar also shows the:

  • Opening price
  • The highest price
  • Lowest price
  • Closing price

But it differs from the candlestick chart because the bars do not have easily visible bodies.

Bar Chart
Bar Chart

The benefits of the bar chart

The bar chart shows some important details about the price movement. Just like the candlesticks, you can see how the highs, lows, and closes of nearby bars are related, and this may have some predictive value. For example, the bars can form patterns, such as the inside bar that you can see in the image above

Line chart

The line chart is a very simple chart and one of the earliest charting technique known. It is constructed with only the closing prices of each trading session. If you mark out the closing prices of the different sessions and connect them with a line, you have a line chart — it’s just that simple.