Technical Analysis

In this lesson
  • What are fundamental and technical analysis and how are they different?
  • What are some helpful ways to understand price movement in markets and what causes it? 
  • What are all those lines people draw on price charts and how can they help to anticipate future price action?
  • What are technical indicators are and what can they do (and not do) to help you make trading decisions? 

Prices Come in Patterns

Technical analysts and fundamental analysts look at different factors to help them decide where a market might be headed. Each method has its merits and successful traders often use a combination of both.

If you were a fundamental analyst trading coffee (not a Nadex contract, by the way) you would travel to Colombia and Kenya and other regions to look at the rainfall, the acres planted, whether the plants were healthy, whether the bean-pickers were on strike, those sorts of things. You might look at the transportation costs or the opinions of experts, all to make an educated guess about the demand and supply of coffee in the upcoming months and what the price should be, based on those expectations.

Technical analysts, by contrast, aren’t so much concerned with what the price should be as what it has been and is right now. They look for patterns and trends that suggest what the market might do next. There are many tools and methods for identifying these patterns and trends, but they’re all based on one premise: the only truth is price.

Patterns of price action

One simple but effective price pattern to look for is the trend. If prices have been in an upward slope they will probably continue upward. Markets often display a version of Newton’s First Law: a market moving in one direction tends to stay in that direction until acted on by another force.

The key word is “probably.” Effective technical analysis means you always plan for the unexpected. With binary options, of course, that risk limitation is built in.

Sometimes the patterns are trends. Sometimes analysts look for top and bottom formations. And some use Fibonacci retracement patterns. If you haven’t heard of those, they’re based on the work of the 13th century Italian mathematician Leonardo of Pisa, known as Fibonacci, who brought to Europe the Hindu-Arabic numeral system and the Indian number sequence known in the West as the Fibonacci sequence.

The Fibonacci numbers, based around the number 1.618, known as phi or the golden ratio, appear throughout nature, in the shape of seashells and pinecones, for example, and they also appear in the behavior of markets. Technical analysts use the ratio of 61.8% as a significant retracement of a market move. Markets often flow in what are called harmonic ratios which create symmetrical moves. Often following a 61.8% retracement, analysts look for an extension of that move, often to 161.8% or some fraction of that number. To a technical analyst, a market that rallies and then drops by 61.8% of the up move is a familiar pattern.

And because it’s familiar, traders will often put their orders near lines that mark Fibonacci numbers or represent breakouts from top or bottom formations.

A final, deceptively simple but powerful way of drawing lines is simply connecting successive highs and lows and then projecting those lines into the future. Markets will often be drawn to those lines.

Moving averages

A moving average is the average of the prices over a certain time period. One type of moving average is called an exponential moving average (EMA), because it gives more weight to recent prices. As averages, they filter out the extremes and help traders visualize the overall trend of a market. Moving averages are not only one of the most commonly used trading tools, they are the basis for calculating many other indicators.

Indicators and oscillators

Technical analysts create and use a large number of indicators, which are usually calculations based on moving averages. Indicators may factor in the volume, the number of up or down ticks in a row, or the momentum of a price move.

Often the crossing of two different lines in an indicator or the movement from positive to negative will suggest a possible change in the trend. Traders use such crossovers to help spot possible turning points in price action.

Over 20 of the most popular technical indicators are available on the Nadex platform. These include stochastics, the moving average convergence-divergence (MACD), the relative strength index, and Bollinger bands. You can adjust their parameters, try different strategies for using them in combination, or consult them along with your trendlines and fundamental analysis.

The important thing to remember about indicators is that no indicator can predict the future. Too many traders get caught up in trying and tweaking various indicators, or even inventing new ones, in a search for a holy grail or something close to it. Sometimes this can result in finding a useful tool, but too often it turns into a distraction or waste of time and energy.

But in the end, there is no holy grail of trading. You are the holy grail, your ability to apply a method consistently, control your emotions, plan for and limit risk, avoid overtrading, and stay focused on the goal, which is not to be right about the markets all the time, but to consistently make money over the long term, preferably without stressing yourself out too much.

 

At this point you should understand:
  • The basic difference between fundamental and technical analysis
  • That price movement in markets is not random, but follows patterns based on the collective thinking of all market participants
  • How technical analysts can use lines drawn between significant turning points in the price charts to project future price action
  • What technical indicators are and how traders use them to predict price action

 

How well do you know Technical Analysis?

You Scored: