To correctly anticipate the price movements of a market, traders use three methods: fundamental analysis, behavioral analysis, and technical analysis. Fundamental analysis studies the value of financial assets, behavioral analysis studies investor behavior, and technical analysis studies the price history of financial markets.
Used by almost all online trading enthusiasts, and particularly suited to short-term trading strategies such as swing trading, day trading, and scalping, technical analysis is applicable to all types of financial assets and products. It allows you to simply identify the current trend on a stock chart as well as the key price levels on which it is interesting to buy or sell. If you want to succeed in the financial markets, you need to understand how it works in detail.
Here is our summary of what you need to know to carry out technical analysis.
Technical analysis studies the price history of a financial asset or product using chartist patterns and technical indicators to determine the current trend and key price levels.
Chartist patterns are recurring geometric shapes on the stock market that can be identified directly on the price curve. They are based on the concept of support (a low price zone in contact with which prices will tend to rebound) and resistance (a high price zone in contact with which prices will tend to correct).
Technical indicators are mathematical formulas that include several variables from the price history (high points, low points, opening levels, closing levels, and volumes), and whose results are presented visually directly on the chart (price indicators) or below the chart (non-price indicators). Although technical analysis is most effective in the most liquid markets (with high trading volumes), this method of analysis is applicable to all stock markets and all time frames.
The founding father of technical analysis, the American Charles Dow, was the first to theorize the concepts of trend and trend reversal in the late 19th century. For the record, the American stock market index Dow Jones Industrial Average owes its name to him! Three distinct phases can be identified in the financial markets :
The trend phases (bullish or bearish) are the easiest to trade, while the ranges require more significant trading experience. If you're new to trading, you'll want to start by implementing trend following strategies. To do this, you will first need to identify the current trend, then determine your entry point (if possible at the beginning of the trend), and finally determine your exit point (if possible at the end of the trend).
But how do you identify the current trend? And how do you know at what price levels to enter and exit the market? This is where technical analysis comes into its own.
The trend is the trader's best ally. To spot trend movements and take full advantage of them, it is possible to draw trend lines, follow fractals, or use technical indicators such as moving averages. Trend lines are straight lines passing through at least three high points or at least three low points on the chart. When a trend line is ascending, the trader can conclude that the underlying market trend is up. Conversely, when a trend line is descending, the trader can conclude that the trend is down.
Fractals are patterns that form at the high and low points of the market. By following the formation of bullish and bearish fractals, the trader can build a channel and clearly identify the market trend. Finally, moving averages are also used to determine the trend of a chart on a given time scale. It is up to the trader to set up this technical indicator by choosing a time unit and a suitable number of periods. (For example, a moving average of 7 periods and 15 minutes time units which will allow to smooth the evolution of the prices and to identify the basic trend).
It is important to note that a trend can very well be bullish in the short term (on a chart in 15 minute time units), but bearish in the medium term (on a chart in 4 hour time units). In order to exploit only the strongest trends that offer the best potential, the trader therefore seeks to identify, as a priority, trend movements that have the same direction on several different time scales.
NB : Here you can use the advanced functions offered by ARYA Trading to respect the current trend, and in particular the trend filter (TrendFilter) by setting the period of its moving average used (MAPeriod).
Knowing the direction of the current trend is a good thing, but it is not enough to make money on the financial markets. Indeed, it is still necessary to enter and exit at the right time to take advantage of the impulse phase and avoid the reversal phase. To know when to buy and when to sell, traders rely on support and resistance levels detected by their technical analysis work. These levels can be simple horizontal or oblique lines that have repeatedly blocked the fall or rise of prices, but also technical indicators such as pivot points (calculated against the previous day's market data). Supports are then used to enter the market to buy or buy back a short position, and resistances are used to enter the market to sell or sell back a long position. While these key levels are often surprisingly accurate, it is still best to take a small safety margin in order to avoid being fooled by "market noise" (made up of very short-term erratic movements of little significance).
Last but not least, technical analysis also allows you to apply essential money management rules, such as the positioning of a stop-loss order. Indeed, once entered in a position, the trader can use technical analysis to reduce risk level or to secure gains by opting for a trailing stop-loss perfectly adapted to trend following strategies. 3 types of trailing stop-losses are generally used by traders :
Depending on their investor profile, a trader can choose to have more or less distant stop orders in order to adjust his risk level. They can also adjust position sizes to be more aggressive when the trend is clear and more cautious when it is hesitant.
Preliminary technical analysis, consisting of identifying a current trend, determining the entry and exit points of the position, and then positioning the stop-loss is relatively simple. Nevertheless, these repetitive tasks can represent many hours of work for traders. Rather than performing their technical analysis manually, traders today prefer to entrust these time-consuming tasks to software, which acts as a strategist and enables them to have their trading systems at their fingertips. In recent years, automatic trading has gradually replaced manual trading.
This new way of using technology to exploit the opportunities offered by technical analysis is detailed in our Masterclass.