What is technical analysis?

What is technical analysis?

Technical analysis (TA), often referred to as charting, is the type of analysis that traders use to predict future market behavior based on past price performance and trading volume data. Technical analysis is popular for analyzing stocks and other assets in traditional financial markets.  TA is also an integral part of cryptocurrency trading in the cryptocurrency market.

Unlike Fundamental Analysis (FA), which takes various factors about the price of an asset into account, TA focuses heavily on past price movements, and many traders use it to identify appropriate trading trends and opportunities.

While the earliest forms of technical analysis appeared in seventeenth-century Amsterdam and eighteenth-century Japan, modern TA often goes back to the work of Charles Dow. Charles Dow, a financial journalist and founder of the Wall Street Journal, was one of the first to realize that assets and markets typically move in trends that we can divide into different sections and examine.

Later, his work developed Dow’s theory, which led to further advances in technical analysis. Technical analysis used to be done on paper and by manual computing, but with the advancement of technology and modern computing, it has become widely used and is now an essential tool for many investors and traders.

How does the technical analysis perform?

As mentioned, TA is essentially an asset study of current and past prices. The main assumption of technical analysis is that price fluctuations are not random and become recognizable trends over time. Technical analysis is the analysis of market supply and demand forces, which reflects the general sentiment of the market.

In other words, the price of an asset reflects the complementary forces of buying and selling. These forces are closely related to the feelings of traders and investors (basically fear and greed). It is worth noting that TA is more reliable and efficient in markets with high volume and liquidity.

High-volume markets are less prone to price manipulation and external influences (which can generate false signals and disregard technical analysis). To check prices and ultimately find suitable opportunities, traders use a variety of chart tools called indicators.
Technical analysis indicators can help traders identify current trends as well as provide good information about trends that will emerge. Because TA indicators have errors, some traders use multiple indicators to reduce risk.

Common indicators of technical analysis

Common indicators of technical analysis

Typically, traders using TA use a variety of indicators and metrics to test and determine market trends. Among the countless technical analysis indicators, the simple moving average (SMA) is one of the most popular and well-known examples.

The SME, as its name implies, is based on the close prices of an asset over a specified period. The Moving Average (EMA) is also a modified version of the SMA, which adds weight to recently closed prices.

Another popular indicator is the Relative Strength Index (RSI). It is a type of oscillator indicator. Unlike simple moving averages, which simply track price changes over time, oscillators apply mathematical formulas to price data and then generate values ​​that fall within predefined ranges.

In the case of RSI, this range is from 0 to 100. The Bollinger Band Indicator (BB) is an oscillator that is very popular among traders. The BB indicator consists of two side bands that are drawn around the price trend of the line. Traders use the Bollinger Bands to identify buying and selling saturation as well as to measure market fluctuations.

In addition to the fundamental and more simplistic tools of TA, some indicators rely on other indicators to generate data. Another well-known example is the divergent moving average (MACD) indicator. The difference between two EMAs forms the MACD signal line.

Traders use the first line to generate another EMA, resulting in the second line (known as the signal line). In addition, there is such a thing as a MACD histogram. Typically, traders using TA use a variety of indicators and metrics to test and determine market trends. Among the countless technical analysis indicators, the simple moving average (SMA) is one of the most well-known examples.

Trading signals

Traders also use indicators to identify potential entry and exit points (buy or sell signal). These signals will generate when we observe a particular situation in the indicator chart. For example, when the RSI is 70 or higher, it could mean that the market is saturated.

Similarly, when the RSI drops to 30 or lower, it is usually considered a sell-saturation signal. As mentioned, the signals provided by technical analysis are not always accurate and contain significant amounts of noise.
This is especially evident in cryptocurrency markets, which are relatively tinier than traditional and naturally volatile.

Criticism

Although technical analysis is popular in markets, many experts consider it to be controversial and unreliable.
The reason for this term is the events that take place, simply because many people imagined it to happen. Critics of technical analysis believe that if numerous traders and investors open accounts on the same indicators, including support and resistance lines, the likelihood of those indicators becoming more effective.

On the other hand, many TA proponents argue that each analyst has his or her way of analyzing charts and uses different indicators. It means that it is almost impossible for many traders to use the same strategy.

Fundamental analysis versus technical analysis

The basic premise of TA is that current market prices have already reflected all the fundamental factors related to assets. But unlike the TA approach, which focuses mainly on historical price data and trading volume (market chart), Fundamental Analysis (FA) adopts a broader review strategy with a greater emphasis on qualitative factors.

According to fundamental analysis, the future performance of an asset depends on much more than just the historical data of the chart. In essence, FA is a method used to estimate the intrinsic value of a company, business, or asset, based on a wide range of micro and macroeconomic conditions such as corporate governance, corporate reputation, market competition, growth rate, and industry health.

Thus, we may consider that unlike TA, which traders primarily use as a tool to predict price performance and market behavior, FA, given its potential and nature, is a way to determine whether the asset is over its value or not.
While short-term traders mostly use technical analysis, fund managers and long-term investors preferred fundamental analysis.

One of the significant advantages of technical analysis is that it relies on quantitative data. In this way, it provides a framework for objectively examining price history and eliminates some speculative behaviors resulting from a qualitative approach to fundamental analysis.
However, technical analysis, despite dealing with empirical data, is still influenced by personal prejudice and mentality.

For example, a trader that desperately wants to reach his or her previous conclusion about an asset, probably because of his or her bias, manipulates technical analysis tools to reflect his or her thoughts, and in many cases, this happens subconsciously. In addition, technical analysis can err in periods when the market does not have a clear pattern or trend.

Conclusion

In addition to long-standing criticism and debate about which method is better, for many people, combining both technical analysis and fundamental analysis approaches is a more rational option.
While traders commonly use fundamental analysis for long-term investment strategies, technical analysis can provide valuable information about market conditions in the short term, which may be profitable for both traders and investors.

 

 

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