Unlike fundamental analysis, which focuses on how micro and macroeconomic forces influence prices, technical analysis deals only with a market’s price history as it is presented in a price chart. Technical analysts contend that all the fundamental factors that influence a price’s behavior, such as trends, investor sentiment, and the supply and demand forces within the market, are clearly visible in a price chart, thus negating the need for traders to watch financial news or study the balance sheets of individual companies.
Traders and investors who use technical analysis have many mathematical tools at their disposal. Most of these tools generate what are called ‘lagging indicators,’ which are values calculated from past price data. The two primary types of indicators are the trend-identifiers and oscillators. Trend-identifiers, such as moving averages, are usually plotted directly on top of the price data, smoothing it out to more clearly show the direction of its trend. Oscillators are typically displayed at the bottom of a price chart, and are designed to gauge short-term investor emotion by giving overbought and oversold signals.
There are a few specialized schools of technical analysis. One of them follows what is known as Elliott Wave Theory, which claims to be able to predict the size and direction of price moves within existing trends, as well as trend reversals. Another school uses Fibonacci numbers in its technical analysis. Fibonacci numbers are numbers that occur with uncanny frequency in nature, and are thought to accurately predict the lengths of market moves and pullbacks.
★ Principles of Technical Analysis
Technical Analysis is the quantitative study of prices and volumes in order to predict the price of an underlying asset like a stock, currency pair, index or commodity. This type of analysis helps traders determine what is likely to happen in the future so that they can make accurate market moves and high returns on their investments.
★ Trend Following
Trend following is a form of technical analysis that looks at historical data on to see if a trend is occurring. A trend is most simply defined as any sustained movement in one direction. By looking at the historical moving average of an asset, one can determine whether or not a trend is developing.
Trading Example :
You are interested in purchasing gold, and want to see if there is an established trend. You look at the 2-day moving average for Gold, as well as the 5-day moving average for Gold. If the 2-day moving average has crossed significantly either above or below the 5-day moving average, you can safely assume that a trend has developed, in either an upwards or downwards direction.
★ Means Reversion
The concept behind means reversion is that assets tend to settle back towards their mean. If a trader can determine the mean of an asset, it will make it much easier to predict the direction accurately and get the high return on the investment.
★ Tracking Momentum
Tracking momentum is a common tool used in technical analysis. By using MACD, an investor can determine whether the momentum of an asset is rising or falling, and place their trade accordingly.
Calculating momentum is a complex affair, but once an MACD indicator is determined, it can be used to track the changes day to day of short-term and long-term averages. If the short-term averages are generally larger than the long-term averages, momentum can be said to be increasing, while if they are smaller, momentum can be said to be decreasing.
★ Pattern Return
Finally, many technical analysts look for patterns in the movement of an asset or sector of the market. Finding these patterns can be somewhat complicated, and false patterns may lead a trader to invest unwisely, but if properly used pattern recognition can lead to long-term profitability.