Technical analysis of the financial markets evaluates the past performance of stocks and forecasts future price movements based on historical data. It involves analyzing charts, patterns, and various technical indicators to identify trends and make informed decisions.
The main premise of technical analysis is that price movements and trading volume are not random. Rather, they follow predictable patterns that can be identified and capitalized upon.
One of the key benefits of technical analysis is that it can be used to identify entry and exit points for trades, helping investors to make more informed decisions about when to buy and sell stocks.
Here are a few reasons why technical analysis is important in financial markets:
Price and volume analysis is a technique used to evaluate the price movements and trading volume of a security over time.
Price analysis involves studying the historical price movements of a security to identify trends and patterns. Some of the key price indicators used in price analysis include:
Volume analysis involves studying the trading volume to identify trends and candlestick patterns. Some of the key volume indicators are summarized below.
Price and volume analysis can provide valuable insights into market trends and price movements. By studying historical price and volume data, traders can identify potential entry and exit points and set stop-loss orders to minimize losses. Additionally, price and volume analysis help traders confirm or refute the findings of other forms of analysis, such as fundamental analysis.
Trend analysis is a technique used to identify trends and patterns in price movements over time. By studying these trends, traders and investors gain insights into market sentiment and make informed decisions about buying and selling securities.
Key elements of trend analysis are summarized below.
Bitcoin Simple Moving Average (source: Morpher.com)
Illustrated above is a five-day day RSI chart for Bitcoin. Note a sharp drop in Bitcoin’s RSI coinciding with the sharp drop in price, leading to an oversold condition.
Market cycles refer to the regular pattern of ups and downs in the stock market. These cycles are driven by a combination of economic, political, and social factors that influence investor sentiment and behavior.
Here is a summary of the four key phases of a typical market cycle.
Understanding market cycles can provide traders and investors with valuable insights into market trends and price movements. By identifying which phase of the market cycle the market is in, traders can adjust their investment strategies accordingly.
For example, during the accumulation phase, traders may focus on buying stocks that are expected to perform well in a growing economy. During the distribution phase, traders may focus on defensive stocks or short-selling opportunities.
Support and resistance levels are key concepts that traders use to identify potential buying and selling opportunities.
Support levels refer to price points where a security’s price is likely to stop falling and potentially reverse course. Support levels are often created when there is a large number of buyers in the market, creating a demand for security at a particular price.
For example, a support level of $16,000 for Bitcoin is designated in blue in the chart reproduced below. At this support level, the price of Bitcoin has repeatedly stopped falling lower, only to bounce back with forward momentum.
Bitcoin Support Level (source: Morpher.com)
If a security’s price repeatedly falls to a support level and then bounces back up, traders may interpret this as a buy signal. And this is exactly what happened when Bitcoin experienced a bit of a bull market around January 15th.
Resistance levels refer to price points where a security’s price is likely to stop rising and potentially reverse course. Resistance levels are often created when there is a large number of sellers in the market, creating a supply of the asset at a particular price.
For example, a resistance level of $24,000 for Bitcoin is designated in blue below. As can be seen from this chart, this resistance level is where the price of Bitcoin has repeatedly stopped rising, only to reverse course.
If a security’s price rises to a resistance level and then fails to break through, traders may interpret this as a sell signal. And this is exactly what happened to Bitcoin as it experienced a bit of a bear market run around March 3.
Candlestick patterns are formed by the arrangement of individual candlesticks on a chart. They display the open, high, low, and closing prices for a given security over a specified period of time, typically ranging from one minute to one month.
Traders use candlestick patterns to time entries and exit trades. These patterns can provide valuable information about the market sentiment, as well as the potential direction of price movement. For example, a bullish candlestick pattern may indicate that buyers are in control, while a bearish candlestick pattern may indicate that sellers are dominating the market.
The Anatomy of a Candlestick (source: Morpher.com)
The candlestick body is equivalent to the difference between the opening price and the closing price. The body is the solid part of the candlestick that is shaded or colored to represent the opening and closing prices.
The wick, also known as the shadow, is the thin vertical line that extends from the top and bottom of the body. It represents the high and low prices during the same period.
The length and thickness of the body provide information about the price movement of the asset. A long body denotes a strong price movement, while a short body denotes a weak price movement.
The color of the body can also provide information about the price movement. Typically, a green body denotes bullish movement, while a red body denotes bearish movement.
Fibonacci retracements are used to identify potential levels of support and resistance.
The Fibonacci sequence is a series of numbers where each number is the sum of the two preceding numbers: 0, 1, 1, 2, 3, 5, 8, 13, 21, and so on. Traders use these numbers, or ratios derived from them, to identify potential levels of support and resistance.
To use Fibonacci retracements, traders first identify a significant price move, such as a sharp rise or a sharp fall. They then draw a horizontal line at the highest point of the move (100%) and another line at the lowest point of the move (0%).
Traders then draw additional horizontal lines at various ratios derived from the Fibonacci sequence, typically at 23.6%, 38.2%, 50%, and 61.8% retracements. These lines represent potential levels of support and resistance.
An example chart illustrating various Fibonacci retracement levels is reproduced below.
Fibonacci Retracement Levels (source: Morpher)
If the security’s price retraces to one of these levels, traders may interpret this as a potential buying or selling opportunity. For example, in the example illustrated above,
the security’s price retraced to the 38.2% retracement level and failed to break through. Traders may interpret this as a sell signal, as it suggests that the security’s price is likely to continue falling. And indeed, this is what happened in the example illustrated above.
The Elliott Wave Theory is based on the idea that market trends are cyclical and can be broken down into smaller patterns that can be used to predict future price movements.
According to the Elliott Wave Theory, market trends move in Motive Waves comprising a series of five smaller waves as illustrated below.
Elliot Motive Waves (source: stockcharts.com)
The impulse waves are numbered 1 to 5, with waves 1, 3, and 5 moving in the direction of the trend. Waves 2 and 4, called corrective waves, move against the trend.
Traders use the Elliott Wave Theory to identify potential turning points in the market and to determine when to enter or exit trades. They do this by analyzing the size and duration of each wave, as well as the relationship between the waves.
The theory is also based on the idea that the size and duration of each wave are related to the overall size and duration of the trend. For example, if wave 3 is the longest and most powerful wave in an uptrend, it is likely that the subsequent corrective wave, wave 4, will be relatively short and shallow.
Traders also use the Elliott Wave Theory to identify potential levels of support and resistance based on the relationship between the waves. For example, if wave 2 retraces 50% of wave 1, it is possible that wave 4 will also retrace 50% of wave 3.
Guppy Multiple Moving Average (GMMA) is a tool designed to identify the direction and strength of a trend and to identify potential support and resistance levels.
The GMMA consists of two groups of moving averages, known as the short-term and long-term moving averages. The short-term group consists of 3, 5, 8, 10, 12, and 15-day moving averages, while the long-term group consists of 30, 35, 40, 45, 50, and 60-day moving averages.
The short-term moving averages are designed to capture the short-term momentum in the market, while the long-term moving averages are designed to capture the long-term trend. When the short-term moving averages reside above the long-term moving averages, it indicates a strong uptrend. When the short-term moving averages reside below the long-term moving averages, it indicates a strong downtrend.
The debate between technical analysis vs. fundamental analysis is one of the most controversial topics in the world of finance. Both approaches are used to analyze financial markets, but they differ in their methodologies and the types of information they use to make investment decisions.
Fundamental analysis is based on the idea that a company’s intrinsic value can be determined by analyzing its financial and economic data, such as its earnings, revenue, assets, liabilities, and management. Fundamental analysts believe that the market may not always be efficient and that there may be opportunities to profit from stocks that are undervalued and overvalued based on their intrinsic value.
On the other hand, technical analysis is based on the idea that market trends, patterns, and behaviors can be analyzed to predict future price movements. Technical analysts believe that all relevant information is already reflected in the price of a security and that past price and volume data can be used to identify potential levels of support and resistance and to make investment decisions.
Like any investment approach, technical analysis has its advantages and limitations.
Technical analysis is an important approach to understanding financial markets and includes key concepts like trend analysis, support, resistance levels, and price action analysis. Technical analysts use a range of tools and techniques, including candlestick patterns, Fibonacci retracements, and Elliott Wave Theory, to analyze market data and make informed trading decisions.
While technical analysis is a powerful approach, combining it with fundamental analysis is important to get a complete picture of the market. Fundamental analysis involves looking at macroeconomic and industry-specific factors that can affect asset prices, such as interest rates, company earnings, and geopolitical events.
Disclaimer: All investments involve risk, and the past performance of a security, industry, sector, market, financial product, trading strategy, or individual’s trading does not guarantee future results or returns. Investors are fully responsible for any investment decisions they make. Such decisions should be based solely on an evaluation of their financial circumstances, investment objectives, risk tolerance, and liquidity needs. This post does not constitute investment advice.
Hundreds of markets all in one place - Apple, Bitcoin, Gold, Watches, NFTs, Sneakers and so much more.