Technical analysis is a trading tool used to evaluate financial instruments or assets to try to forecast their future movement. This is done by analyzing statistics gathered from previous and current trading activity such as price movement and volume. Technical analysis can be viewed as a process of mapping trader and investor psychology.
Market action is studied mainly through the use of price charts and indicators to project the direction of future price movements of an asset or financial instrument. Technical analysis is derived from the Dow Theory with two main assumptions that:
When you look at the price of any financial instrument as a technical analyst you believe that is the true value of the instrument as the market sees it. Using a technical approach, you believe that all the factors that affect price, including fundamental, political, and psychological, have all been built into the price you see. That means that anything that can affect the price of a security has already been factored by the market participants. Technical analysts examine the charts for information on the future direction of the markets.
Technical analysis can be applied to virtually any tradable instrument that is subject to the market forces of supply and demand, including stocks, bonds, futures. indices, commodities and currency pairs. It can be viewed as simply the study of supply and demand forces as reflected in the market price movements of a security.
Numerous technical indicators have been developed to attempt to accurately predict future price movements. Some indicators place emphasis primarily on identifying the current market trend, while others identify support areas, resistance areas, market cycles, strength of a trend and the probability of its continuation as well as identifying overbought or oversold market conditions. The commonly used technical indicators include trendlines, oscillators, moving averages and momentum indicators such as the moving average convergence divergence (MACD) indicator.
Technical analysis can be applied to to charts of various time-frames. Short-term traders may use charts ranging from one-minute to hourly or four-hour time-frames, while traders analyzing longer-term price movement scrutinize daily, weekly or monthly charts. Factors such as risk tolerance, trading objectives and the amount of time that one has to trade determine what time-frame to do analysis and trade on.
HOW YOU COULD UTILISE TECHNICAL ANALYSIS
Map the Trends
Study long-term charts. Begin a chart analysis with monthly and weekly charts spanning several years. A larger scale map of the market provides more visibility and a better long-term perspective on a market. Once the long-term has been established, then consult daily and intra-day charts. A short-term market view alone can often be deceptive. Even if you only trade the very short term, you will do better if you're trading in the same direction as the intermediate and longer term trends.
Spot the Trend and Trade in Sync With It
Determine the trend and follow it. Market trends come in many sizes – long-term, intermediate-term and short-term. First, determine which one you're going to trade and use the appropriate chart. Make sure you trade in the direction of that trend. Buy dips if the trend is up. Sell rallies if the trend is down. If you're trading the intermediate trend, use daily and weekly charts. If you're day trading, use daily and intra-day charts. But in each case, let the longer range chart determine the trend, and then use the shorter term chart for timing.
Find the Low and High of It
Find support and resistance levels. The best place to buy a market is near support levels. That support is usually a previous reaction low. The best place to sell a market is near resistance levels. Resistance is usually a previous peak. After a resistance peak has been broken, it will usually provide support on subsequent pullbacks. In other words, the old “high” becomes the new low. In the same way, when a support level has been broken, it will usually produce selling on subsequent rallies – the old “low” can become the new “high.”
Know How Far to Allow the Market to Pullback
Measure percentage retracements. Market corrections up or down usually retrace a significant portion of the previous trend. You can measure the corrections in an existing trend in simple percentages. A fifty percent retracement of a prior trend is most common. A minimum retracement is usually one-third of the prior trend. The maximum retracement is usually two-thirds. Fibonacci Retracements of 38% and 62% are also worth watching.
Draw the Line or Use an Objective Dynamic Trend Line
Draw trend lines. Trend lines are one of the simplest and most effective charting tools. All you need is a straight edge and two points on the chart. Up trend lines are drawn along two successive lows. Down trend lines are drawn along two successive peaks. Prices will often pull back to trend lines before resuming their trend. The breaking of trend lines usually signals a change in trend. A valid trend line should be touched at least three times. The longer a trend line has been in effect, and the more times it has been tested, the more important it becomes.
You Could Follow that Average
Follow moving averages. Moving averages provide objective buy and sell signals. They tell you if the existing trend is still in motion and they help confirm trend changes. Moving averages do not tell you in advance, however, that a trend change is imminent. A combination chart of two moving averages is the most popular way of finding trading signals. Some popular futures combinations are 4- and 9-day moving averages, 9- and 18-day, 5- and 20-day. Signals are given when the shorter average line crosses the longer. Price crossings above and below a 40-day moving average also provide good trading signals. Since moving average chart lines are trend-following indicators, they work best in a trending market.
Learn the Turns
Track oscillators. Oscillators help identify overbought and oversold markets. While moving averages offer confirmation of a market trend change, oscillators often help warn us in advance that a market has rallied or fallen too far and will soon turn. Two of the most popular are the Relative Strength Index (RSI) and the Stochastics Oscillator. They both work on a scale of 0 to 100. With the RSI, readings over 70 are overbought while readings below 30 are oversold. The overbought and oversold values for Stochastics are 80 and 20. Some traders use 14 days or weeks for stochastics and either 9 or 14 days or weeks for RSI. Oscillator divergences often warn of market turns. These tools work best in a trading market range. Weekly signals can be used as filters on daily signals. Daily signals can be used as filters for intra-day charts.
Disclaimer – Futures, CFD, Margined Foreign Exchange trading, Warrants, Options and Spread Betting all carry a high level of risk to your capital. Only speculate with money you can afford to lose. Futures, CFD, Margined Foreign Exchange trading and Spread Betting may not be suitable for all customers, therefore ensure you fully understand the risks involved and seek independent financial advice if necessary.
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