Technical analysis explained
Technical analysis is a way of studying and analyzing markets and providing insights to inform trading decisions. The practice has been around for centuries; however, it has exploded in popularity over the last 20 years as data and tools have become increasingly advanced. In the age of the internet, more people have access to these tools and are using them to shape their trading plans.
What is technical analysis?
Broadly speaking, technical analysis is the study of markets or securities and their historic price movements. It works on the theory that markets tend to move in consistent, repeatable patterns, so by analyzing previous price action (given similar conditions or indications), these patterns can be identified and their recurrence can be predicted. This information can then be acted on when placing a trade.
In trading, there are many different theories about markets and how to profit from them. One particular theory, the efficient-market hypothesis (EMH), says that all relevant, available information is already accounted for by market price, so it is impossible to ‘beat the markets.’ However, even if this theory is true, no single person could ever digest all information about a market, let alone multiple markets. This is where we look to techniques such as technical analysis to give us a helping hand.
Why is technical analysis important?
Technical analysis is very subjective, but it is an important technique for traders to grasp. These are some of the main reasons why technical analysis is so beneficial:
It’s clear, visual and easy to comprehend. Do note, however, this doesn’t mean that trading becomes any easier. It takes time, patience and will require some study to understand the markets.
The same methodology can be used across multiple markets. Whether you’re looking at futures, forex, commodities or stocks, you can stick with the same method of analysis, provided there is historical data and liquidity available in the underlying market.
You can use technical analysis across multiple time frames to match your style of trading. Short-term scalpers, day traders, swing traders and long-term investors can all reap great rewards by using technical analysis.
Technical analysis is consistent and repeatable. It can be studied and tweaked through back testing to improve results.
How to trade using technical analysis
Technical analysts use a variety of tools and resources; there are thousands of strategies that can be applied depending on the market and the conditions being analyzed.
The main tools that technicians use are:
We will go on to explain each of these tools in more detail so you understand how they can help you trade using technical analysis.
Using charts for technical analysis
Charts are a staple of technical analysis. There are many different types you can use, and much of this will come down to personal preference and your own bespoke trading plan. Gone are the days where technicians were required to draw their charts by hand, which was time consuming and open to considerable amounts of human error. The plethora of online charts now available makes technical analysis accessible, providing historical data as well as up-to-date market statistics. You can process and analyze this data in the most meaningful ways for you.
Some of the most popular types of charts are:
Point and figure charts
Candlestick charts tend to be the most popular; being very visual, they can provide traders with a great deal of information across multiple time frames, offering insight into market sentiment.
Using drawing tools for technical analysis
Drawing tools are used to markup charts, allowing you to record current patterns and make notes of those that may emerge in future. At the core of technical analysis is the ability to spot levels of support and resistance. These levels are used to indicate where a market might turn around or break out from a previous trend or range, and you can record them with your drawing tools. This is very helpful for a busy trader, where making mental notes just isn’t a practical approach.
You can use Nadex drawing tools to mark up a whole host of features on your charts, including:
Simple horizontal and vertical trend lines.
Market patterns such a triangles, head and shoulder patterns, or ABC patterns.
Mathematical market theories, such as Fibonacci retracements and extensions, Gann fans, Gann lines, and Elliot Wave levels.
Each of the drawing tools can be customized to fit your individual preferences.
Using technical indicators: how can they help you?
Charts are there to be analyzed, and you’ve got your drawing tools at your exposure – but what are you actually looking out for? This is where technical indicators come in. Based on mathematical calculations, technical indicators are tools used to interpret charts, alerting traders to particular patterns or points of interest that could signal an opportunity.
Technical indicators can be put into three main categories:
Trend indicators. These show the general direction of the market and can be used to pinpoint trends. You might also hear them being called oscillators, as they move in a wave-like pattern between highs and lows. Popular trend indicators include moving averages, Ichimoku, and moving average convergence/divergence (MACD).
Momentum indicators. Once a trend has been identified, momentum indicators can show you the strength of this trend and suggest whether a reversal is going to occur. Some of the most important indicators in this category are the Williams %R, the relative strength index (RSI), and one simply known as the momentum indicator.
Volatility indicators. You can use these to see how much prices are changing over a given period; higher volatility means faster price changes. Do be aware that volatility indicators don’t show market direction, just price ranges. Popular indicators in this category include standard deviation, average true range (ATR), and Bollinger Bands®.
Learn more about specific technical indicators and how you can use them to trade.
Fundamental analysis vs. technical analysis
Technical analysis: forecasts price movements based on analysis of past charts and other technical indicators.
Fundamental analysis: studies all internal and external factors that impact pricing to ascertain whether an asset is underpriced or overpriced.
The two techniques differ in that technical analysis looks at pricing data as one singular entity. With this all-encompassing approach, it could be considered a study of human psychology and the ways in which people’s deep-rooted thought patterns are expressed en masse through the markets. On the other hand, fundamental analysis studies many different factors that all have an impact on price. It looks at the ways in which market price is achieved, rather than taking the end result at face value.
The two approaches are different but are not necessarily opposing. As a trader, it is up to you to decide on the approach you will take. Some traders rely on one method of analysis, while others combine various techniques to arrive at conclusions in their own unique way.
To summarize, these are the key points to remember:
Technical analysis is the study of historical price movements of a market or security.
It is based on the theory that markets flow in repeatable, quantifiable patterns.
Traders use technical analysis to flag patterns and trends so they can spot opportunities.
The analytical process is carried out using charts, drawing tools, and technical indicators.
Technical analysis is an enormous field and there is always more to discover – mastering it can take a lifetime. When starting out with technical analysis, it’s important to keep it simple so you don’t get overwhelmed. Approach learning at your own pace and enjoy the journey.
Practice makes perfect. Try out technical analysis using Nadex charts, without any risk. Open a demo account.