What is the essence of technical analysis?
Technical analysis uses recognizable chart patterns and mathematical indicators to predict market dynamics. It is assumed that the market’s opinion about an asset is determined by its price at a given point in time.
Fundamentals of financial institutions, such as earnings per share or government data, are not included in technical analysis. Strict adherence to the principles of technical analysis is designed to eliminate the error of subjective interpretation. The goal is to form an objective assessment of the market, eliminating emotional factors that can influence the decision-making process.
Basic technical analysis tools
Support and resistance levels are the main components of technical analysis. Support levels are any prices below current levels that can prevent the market from falling. Resistance levels, on the other hand, are marks that can limit a rally.
The 52-week high is an example of a resistance level; Accordingly, the 52-week low often acts as support.
Types of technical analysis
Graphical analysis suggests that the market dynamics will repeat itself in the event of a previously observed pattern. Experts identify classic and candlestick patterns, as well as Elliott waves.
- Classic patterns have been used for decades to find continuation and reversal patterns. The former include pennants, flags, and triangles, while the latter include double and rounded extremes and the head and shoulders (H&S) pattern.
- Elliott wave analysis relies on the golden ratio of the Fibonacci series to identify 5-wave trends and 3-wave retracements.
- Candlestick analysis uses open and close levels, as well as highs, lows of certain periods (days, weeks, etc.), which helps to identify patterns of continuation of the movement (“bullish” candles with a long body) or reversal (hammers and shooting stars) . Each type of pattern has its own techniques for identifying support and resistance levels and possible price action.
Simple moving average
Another technical indicator used by analysts is the simple moving average, which is the average price of an asset over a certain period of time. For example, the 8-day moving average is the average closing price of each of the last eight days.
As the name implies, the tracked series changes over time, forming a line on the charts, showing the direction of the market: in a bull market, prices are above the average, and in a bear market, prices are below.
The moving average line itself can act as support or resistance if the market shows an appropriate reaction to its testing. Additional signals are formed when moving averages cross. For example, a bearish signal will appear if the 8-period moving average crosses down the 40-period moving average. Weighted and exponential averages are also used in technical analysis.
Oscillators are more complex technical indicators. They take a neutral value in the middle of their range (near zero or 50, depending on the indicator). Extreme values signal overbought or oversold conditions. This category includes the relative strength index (RSI), stochastic oscillator, MACD and momentum.
Each of these indicators is bullish when up and bearish when down. The direction is confirmed by the intersection of the midline. RSI and stochastic oscillator take values from 0 to 100: above 70 the market is considered overbought, and below 30 – oversold.
Another important category are trend indicators such as the Average Directional Movement (ADX) indicator. They allow you to determine the strength of the impulse, as well as assess the probability of reaching target levels, determined separately for each template. These indicators do not reflect specific levels or direction, but help analysts evaluate the likelihood of a continuation of the movement.