Quick Start Guide to Technical Analysis
Chances are that you’ve seen examples of technical analysis hundreds or even thousands of times as you’ve searched the web for information on particular stocks, crypto, or other assets. Most of the time, when people post images of charts along with their trade calls, they’re sharing examples of technical analysis (either their own, or someone else’s). Technical analysis is one of the most popular ways to analyze which assets to buy or sell, and, critically, when. In this quick start guide, we examine some of the most important questions for those starting out with technical analysis, including: What is technical analysis? Who uses technical analysis? And, what are the different types of technical analysis?
What is technical analysis?
Technical analysis is a popular, yet at times quite complex, means of researching stocks, crypto, and other tradable assets based on their price history.
It is generally accepted that modern technical analysis dates back to the middle of the 20th century when Charles Dow, founder of Dow Jones & Company, began plotting share prices on a chart.
While technical analysis can be used to develop opinions on the overall health of an asset over time, it is more often than not employed to determine the best timing for a particular buy or sell transaction. Most traders using technical analysis are doing so to select, to as precise a point as possible, the price level to enter and exit trades. Traders believe that the previous price action of a particular asset is a valuable indicator of how it might perform in future, and that there are repeatable behaviors and psychologies in the markets that indicate how a price might change in time. In other words, for some traders, the past really is the best indication of the future (albeit not a perfect one). Traders are said to be able to ‘read charts’ because, over time, they develop an intuition around the repeatable patterns and price movements.
As with fundamental analysis, there are several different ways of conducting technical analysis, and traders’ opinions on which techniques are the best vary considerably.
Who uses technical analysis?
As a general rule, it is short-term traders (especially day and swing traders) who use technical analysis most often in their trading decisions. Value-based traders (or value investors, as they are more commonly known), who look for assets to invest in based on there being a difference in the current market price of the asset and their perception of the intrinsic value of the asset, also use technical analysis. Value investors, however, tend to do so over much longer time frames (monthly charts, for example) as opposed to the shorter time frames (15 minute, 1 hour, and 4 hour charts, for example) that day and swing traders do.
Because of the plethora of charting tools available to traders, it is just as common for retail (individual) traders to use technical analysis as it is for trading firms and large financial institutions.
While it is possible to construct a purely technical trading system that uses no fundamental analysis at all, most traders find that combining technical analysis with at least some fundamental analysis provides them with a more complete view of market activity.
What are the different types of technical analysis?
The more you learn about technical analysis, the more you’ll realize it is a large and complicated topic. That said, there are some absolute basics that – once internalized – give you a solid foundation upon which you can build your own technical trading preferences and methodologies. These include understanding different chart types and the role of chart patterns. More information on the most common chart formations can be found here.
Technical analysis takes place on digital charts that present the price history of an asset during a set timeframe as chosen by the user. For the most part, traders use one of three chart types to display this data: candlestick charts, line charts, or HLOC (high-low-open-close) charts (also known as bar charts).
While there is an element of personal preference in which chart you use, there are some advantages and disadvantages to all types and some assets might be better suited to certain types of chart.
Candlestick charts are the most common type of chart used by traders. They are called candlesticks because key data points in the price action (the opening price, closing price, highest price, and lowest price) are displayed in a candlestick shape (a rectangle showing the opening and closing prices, which is like the body of the candle; a thinner line or lines coming out the top or bottom of the rectangle that represent highest and lowest prices of the timeframe, which look like the wick of a candle; and the green or red coloring to denote a higher or lower close than the previous time frame). Candlestick charts can be used with most asset types, including stocks, crypto, forex (foreign exchange), and commodities. These charts are suited to intermediate and advanced traders as the exact shape of the candlestick represents a lot of ‘hidden’ data about the underlying market psychology of the price action.
Line charts are typically used by beginners who require less information on the exact price action and are more interested in the overall trend of the price and any patterns that have formed or are emerging over time. Usefully, line charts eliminate some of the more subtle pricing information that can detract from an holistic view of the asset’s price history. For this reason, many traders use line charts to complement the fundamental analysis (research that focuses on whether an asset is over, under, or appropriately valued by looking at its financials, competitors, macro/micro market environments, and other factors as required) that they are conducting on company stocks.
Finally, HLOC or bar charts are similar to candlestick charts in that they display the same data points (the opening price, closing price, highest price, and lowest price) and they display a color indicating whether the asset increased (green) or decreased (red) in price over that time frame. But there is also a key difference in that, lacking the thick bodies of the candlesticks, HLOC charts provide a cleaner view of the overall price history of the asset. Some traders believe that removing the bolder color indications of the candlesticks allows for a purer and less psychological analysis of the pricing data. Whether this is ultimately the case usually comes down to a trader’s personal beliefs and preferences.
Chart patterns in technical analysis are useful
for visualizing price history and trying to predict what might come next. While patterns cannot guarantee future pricing, they are fairly reliable when identifying trends. Technical analysts use price patterns to distinguish between rising and falling trends in a general sense, and otherwise look for recognizable patterns that indicate how that trend will likely change, or indeed likely will not change, in future.
When a pattern is identified, the next step is to determine whether it is signaling a change or a continuation in pricing: a reversal pattern is a price pattern indicating a change in trend direction, whereas a continuation pattern is an indication that the trend will continue in its existing direction following a brief pause.
As an example, let’s look at the common bull pennant formation. The bull pennant pattern formation is a bullish continuation formation that looks like a triangular flag.
In a bull pennant, the price swings back and forth between two converging trend lines in the pennant. For this pattern to complete, the price needs to break out above the upper trend line, which would confirm that an uptrend is resuming.
The bull pennant pattern occurs after a strong uptrend, which is represented by a sharp increase in price that looks like the flagpole on the chart image. Bull pennants are usually found in the later stages of an uptrend, when the price has gone up significantly and needs to consolidate. If you’re planning to go long (buy), wait for the breakout above the upper trend line to confirm that bulls are back in control of price action. If, on the other hand, you’re planning to go short (sell), wait for the breakout below the lower trend line before entering. Many conservative traders also look for a retest and rejection of these levels prior to entering a new trade in either direction.
Some of the most common chart patterns to learn include:
- Ascending triangle
- Descending triangle
- Symmetrical triangle
- Pennant or flags
- Head and shoulders
- Cup and handle
- Double top
- Double bottom
- Rounding bottom
Where to find out more about technical analysis
Technical analysis may seem daunting at first, but once you have reliable sources of information and a grip on charting basics, you can start putting your new skills into practice. If you are looking to compare your charting conclusions with other traders and get advice and suggestions on how to improve, try Traderverse. Our charting tools are second-to-none and integrate exclusive community features that help you get feedback rapidly, with plenty of time to adapt before your intended trade. For more information, sign up at Traderverse.io or join us on our Discord or Telegram group.