Technical analysis is a security (financial instrument) analysis methodology for forecasting the direction of prices. It is based on the study of past data, primarily price and volume. Like weather forecasting, technical analysis does not result in absolute predictions about the future. Instead, it can help investors anticipate what is likely to happen to price over time. Technicians using charts search for price chart patterns which give them a certain probability of what price might do in the near, medium or long term.
One of the fundamental principles in technical analysis is that market’s price reflects all relevant information, so their analysis looks at the history’s security’s trading pattern rather than external divers such as economic, fundamental and news events. Another principle is that price action tends to repeat itself due to investors collectively tending toward pattern behavior. Technical analysis is focusing on identifying trends and conditions.
You don’t need an economics degree to analyze market index chart. Technical analysis’s beauty lies in its versatility. The principles of technical analysis are universally applicable. Charts are charts. It does not matter if the time frame used is of 1 hour, 1 day or 1 month, it also doesn’t matter if it is a stock, commodity or currency pair, the basic principles of technical analysis are applicable to any chart.
Technical analysts consider the market to be 80% psychological and 20% logical. The price set by the market reflects the sum knowledge of all participants. These participants have considered (discounted) everything under the sun and settled on a price to buy or sell. These are the forces of supply and demand at work. By examining price action to determine which force is prevailing, technical analysis focuses directly on the bottom line: What is the price? Where has it been? Where is it going?
It makes sense to focus on price movements, if the objective is to predict the future price. By focusing on price action, technical analysts are automatically focusing on the future. The market is thought of as a leading indicator and generally leads the economy by 6 to 9 months. A technician will refer to periods of accumulation as evidence of impending advance and periods of distribution as evidence of an impending decline.
For each stock, commodity, index or currency pair, an investor would analyze long-term and short-term charts to find those that meet specific criteria. For a trader to be able to use technical analysis he should know the basic elements which are:
A time frame in technical analysis represents a certain time interval in which the prices move. Time frames can be chosen from the trading platform. The range of time interval starts with 1 minute and goes up to 1 month. Knowing the difference between time frames, will help a trader to better read and understand the chart and price action.
Most used time frames are: 1 minute, 5 minutes, 15 minutes, 30 minutes, 1 hour, 4 hours, 1 day, 1 week, 1 month.
In technical analysis there are many types of time frames, but the three types that are frequently used by investors and traders, depending on the information that they are seeking and their individual skills, are: the line chart, the bar chart and the candlestick chart. Notice how the data used to create the chart is the same, but the way the data is plotted and shown in the charts is different.
Line Chart – It is the most basic of the three charts because it represents only the closing prices over a set period of time. It is created by a line which connects the closing prices on a certain timeframe. Line charts do not provide visual information of the trading range for the individual points such as high, low and opening prices.
Bar Chart – The bar chart expands on the line chart by adding several more key prices of information to each data point. These carts
are made up of a series of vertical line that represent each timeframe. On the vertical line are represented the open price (little horizontal line on the left), the closing price of the time frame (horizontal line on the right), the high and the low of the trading period. A general rule for a bar chart is: If the opening price is lower than the closing price of a certain timeframe, the bar is up; if the opening price is higher than the closing price than the bar is down.
Candlestick Chart – This type of chart displays the high, low, opening and closing prices for a security for a specific timeframe. The wide part of the “candlestick” is called the “real body” and tells investors whether the closing price was higher or lower than the opening price (red/black if the instrument closed lower, green/white if the instrument closed higher). The so called shadows show the trading session’s high and low and how they compare to the open and close. A candlestick’s shape varies based on the relationship between the high, low, opening and closing prices.
Candlesticks reflect the impact of investors’ emotions on financial instrument prices and are used by technical analysts to determine when to enter and/or exist trades. There are many short and long term trading strategies based on candlestick patterns.
The colors of a candlestick chart are highly customizable. Green/Red and White/Black are the default combinations but there is no conditioning in using them. You will see in the following examples a combination of Blue/Red.
Technical analysis can be as complex or as simple as you want it. The first step would be to identify the overall trend. The easiest way to determine whether a trend is ascending or whether it is a descending one is through peak/trough analysis. If the price action draws rising peaks and rising troughs, we can deduce that the trend is rising. If the price action draws falling peaks and falling troughs, the trend is descending. Other methods can also be used, like trend lines and moving averages.
A support level is a price level where the price tends to find support as it is falling. Meaning the price is more likely to bounce off this level rather than break through. Once the price has passed the support level it is likely to continue dropping until it finds another support level.
A resistance level is the opposite of a support level. It is where the price tends to find resistance as it is rising. This means the price is more likely to bounce off this level rather than break through it. Once it has passed above this level, by an amount exceeding some noise, it is likely that it will continue rising until it finds another resistance level.
Often the broken support tends to become resistance and the broken resistance tends to become support.
It is very important to correctly read and interpret the price action of a financial instrument. The basic knowledge in reading the price action used frequently will help traders to develop analytical and prediction skills.
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