Technical Analysis (key things to know)
Technical analysis (TA) is a widely used trading methodology employed by a vast array of market participants ranging from retail traders to institutions. It is a form of analysis that examines and predicts price movements in financial instruments by using historic prices, past market data, chart patterns and indicators to form the basis of a well-formed prediction of future prices. Below are some popular and widely used components of TA that should be considered for sound trading and investing decisions.
Price action is essentially the movement of a security’s prices over time and are a basis for price patterns. It is important to identify price patterns using a series of lines or curves as they help identify areas of support and resistance. In general, places of support offer an area at which traders/investors can look for long entries whereas places of resistance offer an area at which there are opportunities to sell. Furthermore, trends can be established by connecting 2 or more price points. For example, an uptrend occurs as prices create higher highs and higher lows and trendlines that connect the 2 lows indicate support areas. Similarly, downtrends occur as prices create lower highs and lower lows and trendlines that connect 2 lower highs indicate resistance areas.
Indicators are tools that can aid in better understanding and making swift decisions on price movements. In general, there are 3 main types of indicators that can be used namely trend following, oscillators and volatility indicators. Moving averages such as the simple and exponential moving averages are the most popular of the trend following indicators. Oscillators such as the RSI and Stochastics provide information on the momentum developments of a security. Volatility indicators such as the ATR measure how large the upswings and downswings are: low fluctuations indicate low volatility and higher fluctuations indicate higher volatility.
Chart patterns broadly fall into 3 main categories namely continuation, reversal, and bilateral patterns. Continuation patterns such as wedges, rectangles, and pennants signal that the current trend will continue its trajectory in both bullish and bearish cases. Reversal patters such as double bottoms/tops, head and shoulders, rising and falling wedges signal that the current trend is about to change its direction. For example if a reversal pattern forms during an uptrend, say by a double top, we can expect prices to reverse and head lower. Lastly, bilateral patterns which are relatively trickier in nature can signal that the price may move in either direction. A common example of this is the triangle formation such as ascending, descending, and symmetrical triangles.
TA can provide traders and investors with entry, exit and trade management rules for making both short and long-term decisions. Entry points can be derived using certain support levels and when resistance levels are broken whilst exit points can be made clear using certain chart patterns to show the possible range at which investors and traders should start to think about closing their positions.
It is important to note that technical analysis is not a fool-proof method to gain returns. With that being said, sound technical analysis knowledge can provide individuals with a robust framework to develop and manage their trading strategies such that they can reap in potential long-term benefits.