What Is Technical Analysis, And How Does It Work?
Technical analysis refers to traders studying past movements of currency pairs’ prices to predict the likely future direction. It entails pouring over price charts to identify chart patterns with the help of technical indicators. Based on past market data, the indicators should be able to ‘indicate’ where the currency pair’s price will be in the future.
The conviction that guides technical traders is that trading activities are, primarily, a collective behavior. For instance, the market collectively decides to buy a currency pair – with the right catalyst. Therefore, past and present price actions should help traders assign a fair market value to a currency pair.
From the foregoing, the primary function of technical analysis is to identify market participants’ collective actions. In other words, the tools read chart patterns to make sense of the price actions. This way, one identifies the most low-risk and high-return probability trade set up. A trend indicator, for instance, estimates the long-view of the market.
Even then, the technical analysis makes certain assumptions. First, and perhaps the most important, is that history is repetitive. Whatever you see in past data is likely to repeat all over again in the future. Secondly, technical traders discount everything, including the fundamentals of individual currencies in a pair. Third, price action follows trends. Therefore, even random price movements exhibit trends in the long-term.
Chart Patterns that are Critical in Technical Analysis
- Double top
This chart pattern entails price action hitting two peaks, after which it collapses. The price touches a certain level then declines, but just a little bit. On the second attempt, the price seems to terminate at around the same level. It gives you two “tops,” and there is the clearest signal to sell. A double top chart pattern is ideal for spotting a trend reversal. The signal is strongest when the second peak falls slightly below the first peak.
- Double bottom
In like manner, the double bottom is a signal for a trend reversal. The formation appears when the market is trending downwards. In the downtrend, the price forms the first valley but then pulls back a little. The second “bottom” forms when the price fails to go past the first valley level. The buy signal is strongest when the second bottom hangs above the first bottom.
When “Bottom 2” fails to reach the “Bottom 1’s” level, the pressure to sell in the market is waning.
- Head and shoulders
Head and shoulders chart pattern signals a trend reversal from bullish to bearish. The left shoulder forms when the price reaches a peak and then reverses. But the reversal is short-lived as the price climbs back up. This time, the price touches a higher peak from the first one – which forms the head of the pattern. For the second time, the price pulls back slightly to climb back up for the third time. However, the third peak is lower than the second and closer to the first peak – which forms the right shoulder. This pattern can also develop in a downtrend hence signaling a buy.
- Inverse head and shoulders
As the name suggests, the inverse head and shoulders chart pattern is the opposite of the former. It forms when the market is in a downtrend. Identifying the inverse head and shoulders requires the same skills as one would need when identifying head and shoulders chart patterns. First, one should not consider the general trend of the market. It is possible to use the various trend indicators available on trading platforms. Second, one needs to isolate the pair of “Shoulders” and the “Head” pair. It is vital to trace the neckline to ensure that the shoulders are not too far between.
- Cup and handle
Cup and Handle–otherwise called Cup with Handle – signals the continuation of a bullish/bearish trend. The pattern comprises two phases of price consolidation where the first phase – which forms the cup – takes the longest. The market enters the period of consolidation as it takes a break from a previous trend. After a peak forms on the right, the price looks like it is entering a pullback session only to retract and march in the direction of the previous trend. The second phase – which forms the handle – takes place after the new high. Also, the new high forms the right edge of the cup and the beginning of the handle.
Wedge patterns form when the strength in a trend begins to wane. It means the pattern forms in both a bearish and bullish trend. The pattern enables traders to anticipate trend reversal to maximize returns.
A rising wedge forms in an uptrend when the buyers reduce, and the volume transacted begins to peter out. It makes the two trend lines binding the price action to tend to converge at some point in the future. The same is true for a falling wedge, which happens in a downtrend. With time, the price momentum fizzles while buyers begin to scoop up the currency pair in anticipation of a trend reversal. A rising wedge often signals an impending price decline hence a sell signal. A falling wedge signals a buy.
- Bear flag
The bear flag chart pattern signals downward trend continuation. In this formation, traders should spot two main components – the flagpole and the flag. The flagpole is the preceding trend, which is a bearish market is a downward movement.
On the other hand, the flag is the slow consolidation that interrupts the aggressive downward momentum of price action. Once the price action breaks the support line of the flag, then that is the breakout play.
- Bull flag
The Bull flag pattern is the inverse of the bear flag. It forms when the market is in an uptrend, but the match upwards is interrupted by a slow consolidation. The preceding trend, therefore, forms the flagpole, and the consolidation phase forms the flag. Traders of this signal wait for the market to break above the flag’s resistance level before opening a position.
Candlesticks are an excellent representation of price action, but how do they form? Broadly, candlesticks capture the emotion of traders during trading sessions. Different colors of the candles indicate mixed emotions.
A candlestick shows all the prices in a single trading session. It shows the opening price, the close price, the session’s lowest and highest price. The open and close price bounds the candle’s body while the upper shadow shows the session’s highest price while the lower shadow shows the lowest price in the session.
When the bears are in control, the close price of the session appears below the open price. The resulting candle is bearish and usually painted red or black. A bullish candle, on the other hand, forms when the session closes higher. On many trading platforms, a bullish candle is green and white on some.
Candlestick formation could also be a great indicator of the behavior of the market. For example, an inside candle indicates a short-term consolidation phase in the market. Here, a candle forms inside the high and low price of the previous session. If the “Mother Bar” is bullish, then the bulls are likely to be in control after the short-term consolidation.
The opposite of the Inside Bar/candle formation is the engulfing bar/candle. The engulfing candle signifies an impending trend reversal.
Indicators are a technical trader’s invaluable tools. They are mathematical calculations that plotlines on a currency pair’s price chart. By reading the plots, traders can identify signals for entering and exiting the market in the short-term. Indicators are the foundation of technical analysis where users rely on them to anticipate changes in an asset’s price action.
How do traders use indicators? Traders use indicators to read a price chart. The information that chart patterns and indicators produce is what forms the basis of a technical trader’s decisions. Technical indicators show trend, volume, momentum, and volatility.
The moving average (MA) is one of the most popular indicators used in technical analysis. Otherwise called a simple moving average (SMA), MA shows identify the trend of price action. Using historical market data, MA facilitates the identification of support and resistance levels.
Another popular indicator is the relative strength index (RSI), which is a stochastic oscillator. Using readings from 0 to 100, the indicator tells you if an asset is overbought or oversold. Often, it helps traders to confirm probability trade set-ups before making the trade.
The moving average convergence divergence (MACD) indicator is another popular indicator that identifies not only the direction of a trend but also its momentum. Used together with the RSI, the MACD shows you the most appropriate market entry and exit points.
Does technical analysis work?
Technical analysis is more about the behavior of traders than the fundamentals of the asset in question. Since the psychology of traders never changes – for instance, traders will always be susceptible to herd mentality –tracking this behavior should always yield positive results.
Another argument for technical analysis is that traders hold chart patterns and behavior of technical indicators in high regard. By studying chart patterns, traders can easily anticipate the future direction of price action.
Further, the technical analysis considers the trend, price, momentum, and volume of the asset. It is crucial to analyze the volume traded because it tells you what is happening in terms of demand for the asset. Technical analysis tracks the volume and shows traders the general direction in terms of volume moved. Volume traded helps to quantify the strength of momentum in a trend.
Every tool works for different people. As a trading tool, technical analysis works for some traders, but others might find it unhelpful. It all boils down to mastering. Traders who take time to understand how the whole concept of technical analysis works, ends up being master technical traders.
Technical analysis demands that one understands how to use technical indicators, as well as when to use what indicator. Additionally, one must learn to use different indicators, where one indicator identifies a high probability trade set up, and others confirm it. Besides technical analysis, chart patterns are crucial in successful trading.