Technical Analysis: A Primer
Technical analysis is one of the most helpful tools in a trader’s toolbox. You can’t afford not to know about it, so it’s what we explore in this article.
Conventions in Technical Analysis
Price, Volume, and Volatility Exhibit Clear Trends
Technical Analysis Indicators
Technical Analysis Core Instruments
No market trader has an actual crystal ball (at least that we know of!) but all traders can benefit from the next best thing, namely crypto trading technical analysis. This is where we examine previous market performance and use the guidance it provides to assist in predicting which way price movements might go later. It’s a tactic we can characterize as security analysis, just like fundamental analysis so let’s see how it can help day traders.
It frequently sits in contrast to fundamental analysis, which we can apply in both micro and macroeconomic ways. At the micro-level, it takes into account income, expenditure, resources, accountabilities, financing structure, and factors that are described as “soft” elements, things like how good the management team is, or the competitive position.
Doing fundamental analysis at the macro level involves appraising or examining a variety of factors like growth in the economy, inflation, credit cycles, interest rate fluctuations, the transit of capital across borders, the cyclical nature and use of labor and resources, demographic trends, the procedures and activities of governments and nations’ central banks, geopolitical factors, trends in business, shifts in consumer actions, and information from tools like surveys revealing how confident people are about investment markets and assets.
Some market traders are happy using either approach, but many prefer to specialize and utilize the insights gleaned from just one to dictate how they trade.
Unsurprisingly, most brokers and big banks are never slow to latch onto a commercial advantage, and they employ teams that cultivate expertise in a single type of analysis. They realize that the more solid data they can get their hands on, the more chances they have of getting good trading results.
Technical analysts are also sometimes referred to as chartists because they rely on charts to uncover upward or downward movement tendencies in securities. Price patterns may cover support, resistance, trendlines, and candlestick arrangements.
Conventions in Technical Analysis
Although certain market players prefer to utilize both kinds of analytical techniques, the majority favor just one. Some prefer technical analysis because they trust that with price history, “what goes around comes around,” meaning there’s an inherent cyclical nature to price and that there are measurable tendencies in prices, volume, and volatility.
Evolution has favored pattern-seeking in humans. We seek out faces in the clouds because we’ve become adept at recognizing friend from foe, and we look for repeatable patterns in the world around us because that’s helped us to survive. So, it’s natural for traders to seek out repetition in price actions. Individual events will never replicate themselves exactly, but patterns in both longer and shorter-term price performance can show general similarities.
Economic cycles are intrinsically liable to repetition. Credit booms produce ‘bubbles’ when debt rises and eventually exceeds income levels, making loans impossible to service. This usually results in a slow accumulation of gains in shares and similar assets during the growth phase and a steep decline during the resultant recession.
Technicians are resolute in their belief that traders will repeat their previous acquisition and distribution behavior. If they are right about this assumption, the implication it gives rise to is that these repetitions can be tracked down by studying historical sales volume and price information which may be utilized as predictive intelligence about future market behavior. Traders think that if they have seen certain movements before, then they can invest with a greater level of confidence because previous price movements will be repeated.
In technical analysis, this automatically leads to the supposition that market price trumps all the other information that might influence it. Fundamental events like economic information and news do of course influence financial markets, often at the moment they are released, but then the technical analysis will shift its focus towards examining trends in price and to what value market players place on particular information.
For instance, receiving info that reveals that inflation has gone up a fifth of a percent over what the market had been predicated on before this information was shared publicly, it’s possible to look at how asset prices respond in the immediate aftermath to gauge market sensitivity to it.
This kind of analysis makes it possible to recognize things like: if US stock futures drop by X%, the US dollar index goes up by Y%, and the 10-year US Treasury yield goes up by Z%. There are of course many other examples of similar (seemingly) mutually dependent interactions.
One advantage of being aware of such sensitivities is that you can use them to stress test investment scenarios in a bid to better manage risk. For instance, if inflation suddenly went up by 2%, and that wasn’t expected at the time, it’s possible to use data points about surprise inflation increases to work out their effects on a collection of current investments.
Price, Volume, and Volatility Exhibit Clear Trends
One additional thing that is assumed about technical analysis (and about all securities analysis) is that price doesn’t just shift randomly and chaotically. Instead, it’s thought that prices alter because of explicable trends that can be anticipated.
To illustrate this, if we consider a chart for the EUR/USD pair from the middle of 2013 that covers the next four years it would clearly indicate that technical analysis identified opportunities for support and resistance at specific points. When the euro commenced its decline in comparison to the US dollar as a result of a divergence in monetary policy halfway through 2014, technical analysts perceiving a downtrend may have opened short positions on a return to resistance levels. As soon as the trend had disappeared and the market became consolidated, a technical analyst might have decided to invest across the range and begin opening long positions at support while exiting any already open shorts.
To begin with, technical analysis was mostly about understanding the flow and size of price and volume information that emerged from a stock ticker. This began to decline during the 1970s when the wider availability of computers and the seismic shift that accompanied the invention of the spreadsheet culminated in technical analysts having access to an entirely new source of information.
Chart, bar, and later candlesticks became the most frequently analyzed forms of data, alongside regression, moving averages, and price correlations. These days, there are myriad technical indicators available to traders and analysts. It’s feasible to extract information about prices and volumes from trading programs and turn it into any kind of indicator that might interest you. You will need to understand how to code in a way that will be understood by whichever trading software generated the data.
Technical analysis can never gaze into the future with absolute certainty, but it’s still a helpful addition to your toolkit for identifying possible supply and demand mismatches, trends, and behaviors that can be exploited.
You can take various different approaches towards technical analysis. The easiest way of doing it is by using a basic candlestick price chart, indicating price history along with sales and purchase price dynamics within a particular timeframe.
Some create trade ideas by combining a price chart with technical indicators or they use specialist technical analysis, like harmonics or Elliott wave theory. Others pick the parts they like from numerous methods. You have to be careful here because choice overload can do more harm than good. You find yourself paralyzed by options because it’s hard to read a chart effectively when there are too many indicators and lines.
Some traders may even ditch rules altogether (at least temporarily) making trading calls as they see fit because a particular situation seems to demand it.
Others will only execute trades when explicit rules and conditions are satisfied because they don’t want to be swayed by the kind of irrational enthusiasm that defies logic and can affect any of us.
Types of Charts
Candlestick charts will be familiar to almost anyone who’s glanced at trading news. Bullish candles are usually green, but sometimes white. They show where the present price has exceeded the opening price. Red, or occasionally black candles are their bearish opposites.
The body of the candle indicates the distance between closing and opening prices and the distance from the top of the wick to the bottom shows the total daily range.
A candlestick chart share certain similarities with an open-high-low-close chart, or bar chart, but rather than the candle’s body indicating the gap between the opening and closing prices, horizontal tick marks perform that function, with the open tick pointing left and the close tick pointing right.
As you might expect, line charts join data points with a line, most often from the closing price of each period.
An area chart is just like a line chart, but the area below the line is shaded to better show the price movement.
Heiken-Ashi charts use candlesticks for plotting, but they calculate price differently. Rather than having candles show basic open-high-low-close information, prices are smoothed to more effectively show trending price action. Here is the formula they use.
• Open = (Open of previous bar + Close of previous bar) / 2
• Close = (Open + High + Low + Close) / 4
• High = Highest of High, Open, or Close
• Low = Lowest of Low, Open, or Close
Average true range – The range over a particular period, normally daily.
Breakout – When price breaks through a point of support or resistance, frequently because of a significant rise in the volume of buying or selling.
Cycle – Periods when we expect prices to follow a particular pattern.
Dead cat bounce – When a price drops in a down market, it still may see an uptick because buyers think that the asset is now a bargain or that selling has been overdone. But then sellers continue pushing it down even more, so that little surge, the terminally declining asset picks up a final bounce or blip of optimism on the chart.
Dow theory – The Dow theory calls for an upward trend in the market if one of its averages like industrials or transportation exceeds a previous significant high and is escorted or trailed by a comparable increase in the other average.
Doji – A candle type where there isn’t opening and closing prices are pretty close to each other, which points to market indecision.
Elliott wave theory – this is the idea that markets cycle through times of optimism and times of pessimism, so you can base your trades on the anticipated rises and falls of each cycle.
Fibonacci ratios – calculations that pinpoint areas of support and resistance.
Harmonics – price patterns reoccur so Fibonacci sequences can use them to identify turning points in the market.
Momentum – the rate of price change over time.
Price action – market price movements as represented on a chart.
Resistance – A price level where there are lots of sell orders, which makes the price recoil downwards. Additional purchasing volume is usually needed to break through it.
Retracement – A (usually temporary) about-face in the trajectory of the present trend that sometimes ends up returning to a level of support or resistance.
Support – A price level where a great number of buy orders have been placed, causing the price to rebound off it in an upwards direction. It won’t hold if selling outweighs buying activity.
Trend – Price movement that carries on in one direction for an extended period.
Technical Analysis Indicators
With technical indicators, there are typically some kind of mathematical or statistical transformations of price and trading volume data to produce numerical expressions of up/down movement, support and resistance levels, momentum, trend, deviations from a central tendency, ratio(s), correlation(s), among others. Some indicators also express market sentiment, things like short interest, implied volatility, put/call ratios, “fear” or “greed”, and so on.
Technical indicators can be categorized in a handful of ways that include price-based, volume-based, breadth, overlays, and non-chart based.
Average Directional Index (ADX) – Expresses how strong a trend is as an absolute value.
Average Directional Movement Rating (ADXR) – Shows the rate of change in a trend.
Commodity Channel Index (CCI) – Draws attention to cyclical conditions or new trends.
Coppock Curve – A measure of momentum. It was first used for identifying the bottoms of stock indexes in the context of long-term trading.
MACD – Plots how two different moving averages are related; designed to be an indicator of momentum-following.
Momentum – Measures price rate change over time.
Moving Average – A weighted average of prices to identify the trend across a sequence of values.
Relative Strength Index (RSI) – Momentum oscillator calibrated to a 0-100 scale so that rate of change can be measured over a set period.
Stochastic Oscillator – Indicates the present price of the index or security in relation to the highest and lowest prices from a range defined by the user. Helpful in identifying market conditions where over buying and overselling are prevalent.
Trix – Combines trend and momentum.
Money Flow Index – a measure of how much money flows into and out of a stock over a set period of time.
Negative Volume Index – an indicator of when smart investors are most active, which assumes that they trade more on days with low volume and less on days with high volume. This indicator focuses on the daily level when volume is lower than it was on the previous day.
On-Balance Volume – Uses volume as a predictor of successive price changes. Fans of this indicator believe that if volume changes only elicit a weak reaction in the stock, it’s likely to be followed by a price move.
Positive Volume Index – Usually used in conjunction with the negative volume index, this indicator shows when institutional investors are most active, with the assumption that they’re more likely to be active with their buying and selling when volume is low. Focuses on times when volume rises above the previous day’s levels.
Williams Accumulation/Distribution – Looks at differences between security (or index) price and flow of volume. Its purpose is to work out when traders are buying or selling. For instance, when the price hits a new low and the indicator doesn’t follow suit, this indicates that buying is taking place.
Breadth indicators can tell us how strong or shallow a market move is.
Advance-Decline Line – Indicates the number of stocks which gained value in an index against the number that lost value. If an index increases value but only 30% of the stocks are up and the rest are either neutral or down, this uneven distribution indicates the strong likelihood that only one sector is buoyant.
If 97% of the stocks are up but only 3% are down or neutral when the market opens, it shows that there may in fact be no prevailing trend and that “reversion to the mean” day trading strategies might be the better option. Although that said, if an asymmetrical advance/decline carries on, the market may be trending.
Arms Index (aka TRIN) – Amalgamate the total number of stocks that are advancing or declining with their volume under this formula:
(# of advancing stocks / # of declining stocks) / (volume of advancing stocks/volume of declining stocks)
A value less than 1 is seen as bullish; a value greater than 1 is seen as bearish. Volume is the number of shares traded rather than the value in dollars – a clear shortcoming of this indicator as it means bias towards cheaper stocks, which naturally trade at higher volumes. Even so, it is still in current use.
McClellan Oscillator – subtracts declining stocks from advancing stocks in an index to arrive at a ratio and applies two different weighted averages to come up with the value. Most effective when the oscillator and the price are divergent. For instance, when the price is hitting a new low, but the oscillator is climbing to a new high, this could suggest an opportunity to buy. On the other hand, when the price hits a new high, but the oscillator arrives at a new low, it might be the best time to sell.
Overlay indicators are placed over the original price chart.
Bollinger Bands – Uses a basic moving average and draws two lines using standard deviations above and below it to create a range. Frequently traders use it as a mean reversion strategy where the price going over or under the bands is “elongated” and it’s thought that it might have the potential to move back within the bands.
Channel – Two parallel trend lines are set to show a pattern of consolidation and its trajectory. A breakout beyond their limits could be seen to point towards a fresh trend and a possible trading opportunity.
Fibonacci Lines – A support and resistance tool informed by the highs and lows of the latest trend.
Ichimoku Cloud – A ‘one-stop-shop’ indicator that aggregates many others to produce signals.
Moving Average – A trend line that shifts with new price data. For instance, a 40-day simple moving average would display the average price over the last 40 days of trading. Exponential moving averages give the line more weighting towards current prices.
Parabolic SAR – Designed to reveal short-duration reversal patterns, and typically should only be used for markets that are trending.
Pivot Points – Levels of support and resistance ascertained from the previous day’s open, high, low, and close. Day traders often use them to search the market for potential reversal levels.
Trend line – A sloping line drawn between two or more hills or valleys on the price chart. A break above or below this kind of line could point to a possible breakout.
Technical analysis isn’t always about charts or transforming prices with math. Some technicians use surveys that measure consumer and business sentiment to inform their trading decisions.
When investor sentiment leans strongly in one direction surveys can sometimes lean the other. In a bullish market, this might indicate that nearly everybody has invested fully and that there aren’t likely to be any more buyers left to push prices any higher further. This could be a sign that prices will follow a downward trend, or that buying carries more risks than if feeling was running in the other direction.
Technical Analysis Core Instruments
Acceleration bands can add much-needed trend identification to your trading. We look at what they are and how they add to your decision-making process.
When an asset continually closes higher and lower over a set period the Aroon indicator tells you. We take a look at this helpful aid to your trading.
The Aroon oscillator is a step up from the Aroon indicator, extending its functionality to enhance the decision-making of traders, so here’s an overview.
Commodity Channel Index (CCI)
Commodity Channel Index (CCI) is a useful addition to any trader’s toolkit. We examine how it helps to inform trades by highlighting price deviations.
From assessing volume to signaling, Donchian Channels could be the ideal tool for helping traders to benefit from defined boundaries in a volatile market.
Ease of Movement
Add to your trading arsenal with the Ease of Movement Indicator. It suits different charts and alongside other tools, it can help to confirm opportunities
Elder Ray Index
Why not give the Elder Ray Index some consideration if you’re in need of an indicator that will assess bullish and bearish strength in a given market?
Elliott Wave Oscillator
Ralph Nelson Elliott first described wave theory in 1938 and it’s stood the test of time. The Elliott Wave Oscillator puts it to real use in trading.
The Fisher Transform Indicator converts price into a normal distribution, and alongside other tools can find price reversals for traders to act on.
Channels are handy for highlighting price reversals, but you can also use them to work out the direction of a market trend.
Moving Averages come in different varieties, all of them popular, and all of them useful for underpinning trend following systems and confirming other tools.
Negative Volume Index (NVI)
Price Percent Oscillator (PPO)
The price percent oscillator (PPO) is a must for the trend-following trader’s toolkit, tracking momentum using exponential moving averages for better signals.