What Is Technical Analysis And How Does It Work?

Technical analysis is a crucial aspect of engaging in any financial market. Whether it is trading stocks or cryptocurrencies, the concept will always apply. Predicting future market behavior is possible with the right approach. 

Table of contents

  • Why Does it Exist?
  • Understanding The Concept
  • It’s Not Rocket Science
  • Picking The Right Indicators
    • Gauging Market Momentum
  • Technical Analysis Trading Signals
    • Noise and Unreliability
  • Ignoring Most External Data
  • What TA Cannot Predict
  • Conclusion

Why Does it Exist?

Examining financial markets and predicting price movements is crucial for anyone exploring this option. There are many different ways to acquire the necessary data, but interpreting it is often a personal preference. As technical analysis is one of the two “main types” of analyzing financial markets and fundamental analysis, it can help gauge the overall market’s health and where the price may head next. 

Traders engaging with financial markets need to analyze the previous and current market trends. With that analysis, they will then try to predict what may happen in the coming days, weeks, and months. Creating this market analysis is a lot more complicated than one may think, even though market trends and patterns repeat themselves regularly. 

Often referred to as “charting“, technical analysis – TA – is a crucial tool to help determine future market behavior. It is not an exact science by any means, as markets will often behave in unpredictable ways. However, with a lot of data at one’s disposal, it becomes somewhat easier to predict the major market events.

Understanding The Concept

It is vital to understand that technical analysis does not require anything but historical price data. This method doesn’t require any external input, such as quarterly reports, news, or announcements. It is all about using historical price points to your advantage and creating a trading strategy with this data. 

One benefit of TA is how it can provide insights into a market’s price fluctuations, volatility, and overall trading volume. These three factors will help traders determine whether entering a market is a smart move or if the current trend may prove to be too volatile. 

The idea behind this form of market analysis dates back to the 17th and 18th centuries. However, the modern iteration of technical analysis is primarily attributed to Charles Dow, who also helped modernize candlestick charts. 

Today, traders and speculators worldwide rely on TA to make market decisions daily.

It’s Not Rocket Science

To neophyte traders, the concept of technical analysis may seem rather daunting at first. Having to study a market’s current and previous price points sounds time-consuming. Additionally, one needs to find patterns in all of this data and base your trading strategy on it. Not everyone is comfortable with this idea, but the effort will often be worth it. 

Markets work on basic principles of supply and demand. If supply trumps demand, markets tend to become bearish, and prices dwindle. If demand outweighs the supply, a market can become bullish and note higher price points. Buyers and sellers are in a constant tug-of-war for market position.

It is advised to find a market or asset with a lot of liquidity and trading volume. Stocks are often a good fit: foreign exchange pairs, precious metals, oil, and cryptocurrencies. More volume and liquidity will often lead to patterns that are a bit easier to analyze. Furthermore, high-volume markets see far less market manipulation and false trading signals. 

Picking The Right Indicators

Once you have picked a market you consider worthwhile, it is time to look into the toolbelt. Technical analysis requires the use of multiple charting tools or indicators. Every trader has their set of indicators they prefer to use, although it is often best to experiment with different ones for different markets. 

Traders will often deploy the “common” indicators on a price chart first. These include:

  • Moving Averages: a calculated price based on that asset’s closing price within a specific time frame. It depicts how the price is evolving in recent days/weeks/months. 
  • Relative Strength Index (RSI): Its range from 0 to 100 indicates whether a market is underbought, overbought, or still has the potential to continue its current trend by remaining range-bound. 
  • Bollinger Bands (BB): Two oscillating bands tied to the moving average. They measure market volatility, as well as increases and decreases in overall trading volume. 

With those essential tools, it often becomes a bit easier to understand what is happening in a specific market and why that is the case. 

Gauging Market Momentum

With the indicators outlined above, every trader should be able to gauge the current market momentum. As markets can only head in three directions – up, down, or sideways – there isn’t any wrong conclusion to be drawn per se. However, it may prove worthwhile to examine the current market strength before making any financial commitments. 

The Relative Strength Index, or RSI, is an often unvalued tool in this regard. Combined with other tools, such as the Stochastic Oscillator, Moving Average Convergence-Divergence, and Average Directional Movement Index, advanced traders will often find ways to analyze current market sentiment and attempt to make money from it.

Although one may think the market is heading in a specific direction, it is always worthwhile to double-check and even triple-check. Using the different indicators to gauge market strength and comparing the different results is worthwhile, especially when dealing with volatile markets such as Bitcoin or Ethereum. By actively comparing results, traders will also distinguish between an ongoing trend or a potential reversal soon. 

One has to keep in mind that momentum indicators do not confirm or deny a current trend direction. They merely serve to depict the strength of a price movement, or the lack thereof. 

Technical Analysis Trading Signals

Analyzing a market serves one particular purpose: identifying trading signals and capitalizing on them. An indicator can help determine the general trend and finding entry or exit points. These latter two options are what people refer to as trading signals.

It is crucial to analyze the individual indicators accordingly and see what they tell you. An overbought RSI reading is often a sign of an imminent market reversal or period of sideways trading. An RSI of 30 or lower, combined with a lengthy period of narrow Bollinger Bands, can indicate the accumulation phase is nearing its end, and a breakout is imminent. 

Noise and Unreliability

Despite this knowledge, it is pertinent not to follow these trading signals blindly. Financial markets are subject to a lot of noise and false signals, particularly on shorter time frames. Combined with the native volatility of Bitcoin or Ethereum, it makes life a lot more difficult for traders looking to create a trading strategy. 

Additionally, many people consider TA as a “useless approach”. More specifically, analysts and specialists feel that technical analysis works if “enough people believe in the projected path”. As more people engage in TA and draw similar patterns, there may be some truth to this criticism.  

It is advisable to find your path and set of indicators when experimenting with technical analysis. Similar to other methods, paper trading needs to be the first step. It will provide a valuable learning experience and will not wreak havoc on your portfolio if things go wrong. 

Ignoring Most External Data

As mentioned earlier, technical analysis doesn’t require any external data. This makes it very different from performing a fundamental analysis, which often will provide a better overview of why a market is heading in a specific direction. However, the fundamental analysis doesn’t necessarily work for markets such as cryptocurrencies. 

Unlike fundamental analysis, TA doesn’t estimate the intrinsic value of an asset or market. Instead, TA helps determine how to make money quickly, whereas fundamental analysis often looks at a much longer time frame. 

Quantitative data is – in the eyes of many- the primary reason to side with technical analysis over fundamental analysis. If one only cares about price performance, there is no need to look into context, for the most part. Keeping tabs on upcoming or recent developments for a specific asset will always be worthwhile, even if it may not affect the price. 

The downside to using this quantitative data is how bias will become a growing factor of concern. Traders will often reach conclusions that aren’t based on factual data but rather wishful thinking. Unfortunately, TA indicators make it possible to project that “mindset” with ease, creating a series of false trading signals. 

What TA Cannot Predict

As useful as technical analysis is for traders and speculators, it too has its shortcomings. Finding a market that is only subject to supply and demand, and not other factors, is virtually impossible these days. As such, those who rely on TA need to make the following three assumptions:

  • No artificial price changes: a factor that can make or break any financial market. Factors to influence a price include splits, dividends, developer changes, airdrops, and so forth. An artificial drop or increase in value can entirely invalidate a technical analysis until things return to normal. That said, an adjustment to the historical price data may offset some artificial changes. 
  • No extreme news:  Technical analysis is incapable of predicting any news-related events that may impact a market. As businesses or projects are always subject to ongoing developments and changes, the news can easily trigger a bear or bull market. More often than not, normal news will be turned into the “extreme” variant by those trying to influence the price, either for better or worse. 
  • High liquidity: It is very dangerous to assume that a financial market will automatically have very high liquidity. This is especially true where alternative cryptocurrencies are concerned, as those often see some volume manipulation. That said, strong liquidity is always a benefit, as it allows traders to enter and exit market positions quickly. Always do some research to gauge volume strength before taking a position. 

Conclusion

There are many valid reasons to leverage the potential of technical analysis as a neophyte or advanced trader. Analyzing market data and using it to build a new trading strategy can prove worthwhile for those who want to make money. 

The TA approach is not without criticism or bias, two pitfalls that everyone needs to be aware of. Not all markets lend themselves to technical or fundamental analysis. It is crucial to make the right choice before committing money. 

Always test your ideas on paper first. Based on hat feedback and performance, adjust where necessary, but without manipulating the data to make your initial idea come true. 

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