Technical analysis is used by traders to gain insight into the marketplace and its trends. Traders who are not familiar with technical analysis tend to have misconceptions about this discipline and how it can help them. If well understood, analysis can give traders clues on the future direction of price and help in determining the entry and exit points. Here are five important aspects of technical analysis that traders need to know.
Price action holds all market information
To determine the intrinsic value of any given stock, fundamental analysis focuses on items like sales figures and earnings. Technical analysis focuses less on why an asset or stock trades at a certain price and more on where its price is heading. The price information of the stock or asset gives insight into its performance on the market. Technical analysts focus on the momentum driving the trend while determining when and where current market conditions may change.
Psychological factors drive markets
In addition to fundamental values, markets are driven by psychological factors. The increase or decrease in demand for security can be determined by the assessment that traders make regarding the security’s perceived or real value. For example, announcements about earnings growth and strong sales for a certain company might cause traders to have a favorable opinion of the company’s stock. This results in demand for the company’s shares. To identify this, a technical analyst will recognize the improving price action and trading volume.
Trading volume offers important information
Price movements are considered more significant if accompanied by trading volumes that are above average. To technical analysts, large volumes show great enthusiasm and conviction from traders. This is why volume appears on technical trading charts before other technical indicators or tools.
Prices move in patterns and trends
Public perceptions are subject to sudden change. Some times, these changes affect the perception of the stock market in its entirety and the financial markets. Other times, these changes affect a certain market segment or stock. Most of the time, however, prices might move actively without any pointers to explain the reason for movement. At this point, price movements appear random. However, price action falls into trends or patterns.
A trend is the direction of the price of a security over a certain time. Trends are assumed to be active until clear signals indicate their reversal. There are three different types of trends based on direction:
- Sideways trend
Trends have time frames that are important to traders. Price trends can last days, weeks, months, years or a few minutes. Considering the time frame that works for your trading style is important. There is a common belief that longer time frames lead to more useful and stronger trading signals. There are three types of trends based on time frame:
- Primary trend
- Secondary, or intermediate trend
- Minor or short-term trend
Trends are considered a trader’s friend and are central to technical analysis. Traders take advantage of the prevailing trend instead of trading against it.
Trading signals build evidence
Trading signals provide traders with criteria to look out for and assist them in identifying trading opportunities. Using one technical analysis indicator or tool does not give you the full picture of the asset or market, but a fraction of it. On the other hand, using too many tools can result in trader analysis paralysis and becoming overwhelmed by the conflicting trade signals and their number. To build their evidence, traders seek trade signals from combinations of few indicators and tools. This helps traders to make less emotional and more objective decisions instead of reacting to all price movements.
Note that there is no technical tool with a perfect track record for obtaining trading signals. There will always be a chance for conflicting and false signals. In addition, no set combination or number of indicators and tools work for everyone. This is why it is mandatory to know your trading strategy and find clear trading signals that you understand and fit your strategy.
It is important to examine closely technical analysis tools that interest you. This can help you have a better understanding of how the tool works and determine the way it fits with your trade plan and strategy.