Introduction to Technical Analysis

Introduction to Technical Analysis

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What is technical analysis?

Technical Analysis is a concept that can be used to analyze the price movements of financial instruments to earn large profits.

The benefits of technical analysis have been discussed extensively, in many books and articles, but it is important to look at the criticism of this concept. We will also understand the various applications of technical analysis.

Scientists, and especially the proponents of the efficient market hypothesis, compare technical analysis with pure speculation. They claim that an investor performing technical analysis will perform worst than a monkey making random decisions.

On the other hand, several reports confirm that technical analysis might be superior to fundamental analysis in the short-term investment horizon.

There are also various studies by Chinese scholars that recognize that the momentum effect can be a potentially profit-making strategy based on historical pricing patterns.

A study of over 2000 Indian stocks confirmed that the effectiveness of the analysis could be significantly improved with the support of tools such as charting methods and patterns which are observed and derived from those charts.

Another study found that trading systems that use technical indicators might outperform a simple “buy-and-hold” strategy.

Various Technical Indicators using charts

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Technical Analysis and Trends

Prices on the financial markets move, among other things, because millions of people and institutions interact on the international financial markets every day.

Financial market players make buying and selling decisions that influence the pricing of financial instruments and cause upward and downward prices fluctuations.

Technical Analysis is so effective because people always follow the same behavioral patterns and often make their trading decisions collectively based on the emotions, they share.

Most people will already know sayings like “greed is good” or “shares are bought based on expectations and not based on facts”.

This indicates that the human psyche and general thinking patterns are important factors of development in the financial markets. Whether we are looking at a speculator from China 200 years ago, a Wall Street pit trader from New York 80 years ago, or a modern-day Trader – human components, i.e emotions, and instincts, hardly differ.

Greed, fear, uncertainty, and the willingness to take risks have determined human actions every time and, of course, how people have moved their money around for centuries in the world’s markets.

Why do people use Technical Analysis?

Technical Analysis is one of the key aspects to understanding the buying and selling movements in the financial markets when trying to analyze and make smart decisions on entering and exiting a trade.

Technical analysis is so effective is because of the principle of the self-fulfilling prophecy. Since millions of people follow technical analysis concepts and make decisions based on them, they verify that technical indicators and other concepts simply work because they are widespread.

Even the financial media often refer to technical concepts such as past highs and lows, psychologically important price levels, and moving averages.

When we delve into the technical analysis of pricing structures and chart studies in the next few blogs, you will soon realize that technical trading is much more than it seems at first glance.

We will develop an understanding that will enable us to put ourselves in the shoes of other traders and interpret the thought process of financial market players so that we can ultimately benefit from technical analysis through independent strategic thinking.

Most traders carry out technical analysis at a very superficial level since the majority of the literature on technical analysis does not deal with the underlying mechanisms in-depth.

Here, the criticism by the opponents of technical analysis would even be justified, because such an approach is not effective and trading cannot be reduced to surface level thinking.

Through our series of blogs, we will try to cover this subject in a new, efficient and detailed way.

Technical Indicators in Finance

Introduction to Candlestick Analysis

We will start with the fundamentals of technical analysis and then progress to the advanced concepts so that we will be able to interpret and trade with any kind of chart.

Even those who have prior experience trading should not skip the following section. It contains a different approach that is not discussed in traditional technical analysis and is a prerequisite for successful price analysis.

Line Charts

For most people, line charts usually provide the first impression of the world of financial markets because we see them frequently when we open the newspaper or turn on the television.

A line chart can describe the price development of a stock, a currency pair, a cryptocurrency, a commodity, and any other financial value.

The advantage of a line chart is that the information is highly compressed. One glance at the line chart tells you all that you want to know for elementary analysis.

If we see a rising line chart, it indicates a rally or a bull market (a bull thrusts its horn in the air). If the line of the chart shows a falling price, it indicates a bear market (the bear swipes his paws down).

The closing prices for a day are usually plotted and joined together in a line chart. Every day, we move one unit to the right on the scale. This kind of chart is also called a daily chart.

The disadvantage of this line chart is that the price fluctuations within a day – or any chosen time period – cannot be recorded since the line chart shows only the closing prices.

However, we all know that there can be strong price fluctuations in the financial markets, and neglecting them can be a disadvantage for precise technical analysis.

Candlesticks charts

Candlestick charts are further developed line charts that serve to compensate for the disadvantage of less information. Candlestick charts have their origin in 17th century Japan.

Today, candlestick charts are the preferred tool of analysis of traders and most investors since they provide all information at a glance.

What is a Candlestick?

As the name suggests, a candlestick chart is made up of so-called candlesticks. These candlesticks are made up of different components to describe the price movements of financial instruments.

A candlestick consists of a solid part, the body, and two thinner lines which are called candle wicks or candle shadows.

The candlesticks are color-coded to illustrate the direction of the price movements. A green candlestick represents rising prices, whereas a red candlestick represents falling prices.

Japanese Candlestick Charts. Image Source – Shutterstock

The length of the shadows represents how much the price has moved up and down concerning a candlestick within a specific duration. If we set our charts so that one candlestick corresponds to one day, then we can read the daily fluctuations in the market using the shadows of a candlestick.

The candlestick body describes the difference between the opening and closing prices for the corresponding time period.

If we line up several candlesticks, we can reproduce the progression of line charts by following the bodies of the candlesticks.

The candle fluctuations show the movement of the instrument over a given period of time and hence provide a good idea of which direction it will move next. This is one of the major reasons why people candlesticks for technical analysis of various markets.

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