Technical analysis

Technical analysis is also referred to as chart analysis. In contrast to fundamental analysis, which is usually based on complicated models, technical analysis tries to create price forecasts based on past chart performance. It means searching the chart for specific price patterns.

How does technical analysis work?

Technical analysis is a broad field of indicators, oscillators, trend lines, and chart patterns. The variety of approaches makes it difficult to list everything in full. Due to this, we are going to focus on the main approaches here.

What are indicators?

The indicators are mathematical or statistical calculations based on price, time and volume and are therefore part of technical chart analysis.

What are oscillators?

Oscillators come from the group of technical chart indicators. The calculation is based on mathematical and statistical price data. The development often happens between an upper and lower limit and thus shows extreme phases in the price development of a particular derivative. One of the best-known oscillators is the stochastic indicator.

Instruments of technical analysis

1. Trends and trend recognition

2. Trading margins

3. Support and resistance lines

4. Chart information:

  • Flags

  • Pennant

  • Triangles

  • Wedge

  • Gaps

  • Reversal bars

  • Top and bottom formations

  • V-tops and V-floors

  • Head and shoulder formations

  • Saucer formation

  • Island reversal

  • Double tops and double floors

5. Indicators and oscillators:

  • Moving averages

  • Momentum oscillator

  • Rate of change

  • Relative strength index (RSI)

  • Moving average channel

  • Moving average convergent divergence (MACD)

  • Bollinger bands

All methods of technical analysis developed from a desire for a certain degree of certainty in trading and to find specific entry setups that generate reproducible profits. The basic assumption when analysing prices is that all information is priced into the prices. After all, no matter who may have an information advantage on the market, they will have to enter their order into the order mask and thus move the prices in the end. Even the analyst with a fundamental approach has to place the order on the market sooner or later. The overall behaviour of all market participants can be seen in the price trend accordingly. This knowledge will now permit derivation of actions for the entries and set logical stops.

Traders thus must figure out who will be buying or selling after them in order to find entry setups. This is the only way to make a profit. For this reason, chart analysis now attempts to recognise situations in the chart where it can be assumed that other market participants will also enter or exit after the entry. They try to keep up with the big investors who move large amounts of money to be on the safe side. A large investor will never get into a stock all at once, as otherwise they will lower their own entry price. As a result, it will enter the market in stages. Every time prices are favourable, they will build up part of their position. This will create trends as investors buy (long) or sell (short) during correction phases.

Chart types

The different types of charts result from the different trading approaches. Each chart has particular advantages that make visualisation of some details easier. The bar chart is the most widely used chart.

  • Bar chart

  • Candlestick chart

  • Kagi chart

  • Line chart (chart based on closing price)

  • Point and figure chart

Why does technical chart analysis work?

The chart as a useful indicator of future price trends is a highly controversial subject. Random walkers are a group of economists who believe that price movements are strictly random. Charts thus can only reflect the past without offering any conclusions regarding the future. Random walkers forget that prices are a result of the price positioning on the stock exchange and that this in turn is based on the aggregated activities of all market participants. This is why a chart also shows the fundamental behaviour of the players. Trends would not appear as clearly in a randomly generated chart as it does in the actual price position. Market participants thus generate similar price patterns by their decisions, from which rules for the future can be derived. For this reason, there are also violent movements when the price rises above or falls below certain points on the chart. This would not happen if prices were determined randomly.

Unfortunately, mathematical proof of the technical approach is not possible since price patterns cannot be defined precisely. Looking at a trend, for example, will bring up the question of when it is broken and when it is not. If the trend is broken by a spike, for example, before turning back in its original direction, it will have been mathematically broken. However, a trader might use this as a signal (for example, a reversal bar) to trade in the direction of the original trend, knowing that the trade is likely to bring about a profit. Of course, traders know that there are also some random price fluctuations. This is called market noise. This means that they only ever have a certain probability to work with.

Generally, however, human behaviour on the markets creates chart patterns that are recurring. The chart thus can be used to forecast future price movements. Furthermore, it is also useful for risk and money management, as market participants are forced to act at certain points in the chart. As a result, it is possible to determine in advance where a trading idea will fail.

Who uses technical chart analysis?

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