Technical analysis is also known as chart analysis. Unlike fundamental analysis, which is usually based on complex economic models, technical analysis tries to forecast prices on the basis of how the chart has developed in the past. To do this, the chart is searched for specific price patterns.
How does technical analysis work?
Technical analysis is a broad field made up of indicators, oscillators, trendlines and chart patterns. The approaches are so varied that it is difficult to list them all, so this overview concentrates on the most important ones.
What are indicators?
Indicators are mathematical or statistical calculations based on price, time and volume. As such, they are an integral part of technical chart analysis.
What are oscillators?
Oscillators are a group of technical indicators. They, too, are calculated from price data using mathematical and statistical methods. Their values usually fluctuate between an upper and a lower limit, which allows them to highlight extreme phases in the price development of an instrument. One of the best-known oscillators is the stochastic oscillator.
Tools of technical analysis
- Trends and trend identification – see Trends
- Trading ranges
- Support and resistance lines
- Chart patterns: flags, pennants, triangles, wedges, gaps, reversal bars, top and bottom formations, V-tops and V-bottoms, head-and-shoulders patterns, saucer formations, island reversals, double tops and double bottoms
- Indicators and oscillators: moving averages, the momentum oscillator, rate of change (ROC), the Relative Strength Index (RSI), the moving average channel, Moving Average Convergence Divergence (MACD) and Bollinger Bands
All methods of technical analysis grew out of the desire to bring a degree of certainty to trading and to find concrete entry setups that can be repeated and are meant to deliver consistent results. The basic assumption when analysing prices is that all available information is already reflected in them. No matter who may have an information advantage in the market, in the end they have to enter their order – and in doing so, they move the price. Even an analyst who takes a fundamental approach has to place their order in the market sooner or later. Consequently, the behaviour of all market participants can be seen in the price chart. Traders use this knowledge to derive rules for their entries and to set logical stops.
To find entry setups, a trader therefore has to ask: who will buy or sell after me? Only then is a profit possible at all. This is why chart analysis tries to identify situations in which other market participants can be expected to enter or exit after you. To be on the safe side, traders try to swim with the large investors who move large sums of money. A large investor will never enter a position all at once, as this would worsen their own entry price. Instead, they enter in stages and build up part of their position whenever prices are favourable. This is how trends emerge: during the correction phases, these investors buy more (long) or sell more (short).
Types of charts
The various types of charts reflect different trading approaches. Each chart type has its own advantages and shows certain details more clearly than others. The bar chart and the candlestick chart are among the most widely used.
- Bar chart
- Candlestick chart
- Kagi chart
- Line chart (based on closing prices)
- Point and figure chart
Why does technical chart analysis work?
The value of charts as an indicator of future price developments is a highly controversial topic. Supporters of the random walk theory, a group of economists, believe that price movements are purely random. In their view, charts can only show the past and allow no conclusions about the future. Chart analysts counter that prices are the result of price formation on the exchange, which in turn is based on the aggregated activity of all market participants. A chart therefore also reveals the basic behaviour of those participants. In a randomly generated chart, a trend would not appear as clearly as it does in real price data. Through their decisions, market participants create similar price patterns again and again, from which rules for the future can be derived. This is also why sharp movements often occur when significant points on the chart are broken to the upside or downside – something that would not happen if prices were set at random.
Unfortunately, the technical approach cannot be proven mathematically, because price patterns cannot be defined precisely. Take a trend, for example: when exactly is it broken, and when is it not? If a trend is broken by a brief spike but the price then turns back in the original direction, the trend is broken from a mathematical point of view. A trader, however, might use exactly this as a signal – for example a reversal bar – to trade in the direction of the original trend, because in their assessment the trade is more likely to end in profit. Traders are of course aware that some price fluctuations are random; this is known as market noise. So a trader only ever has a certain probability on their side, never certainty.
In general, however, human behaviour in the markets produces chart patterns that recur again and again. From a technical analyst's point of view, charts are therefore a useful tool for forecasting future price movements. They are also valuable for risk and money management, because at certain points on the chart, market participants are forced to act. This means traders know in advance at which point a trading idea is no longer valid.
Who uses technical chart analysis?
Technical analysis is used by a wide range of market participants: private traders, professional traders at banks and trading firms, and analysts who regularly publish market analyses and point out potential entry opportunities. It is particularly widespread in short-term trading, for example in forex and CFD trading, where the timing of entries and exits is crucial. Many traders combine it with fundamental analysis: the fundamentals help them decide what to trade, while the chart helps them decide when. The trading platforms offered by brokers usually include charting tools with the chart types and indicators described here.