Technical analysis is the study of asset prices in the attempt to determine the future direction of a market. Market practitioners who use technical analysis believe that the majority of the information that is available is already incorporated in the value of an asset. With this in mind, a study of the price action will help determine the next move of the financial instrument. There are multiple types of technical analysis that individuals practice to determine futures prices.
The art of technical analysis can be helpful in assisting an investor with entering positions, exiting positions, and managing the risk of a position. Technical analysis is categorized into different subjective and objective studies that allow different traders the ability to accomplish different tasks. Some of the objective studies include, trend following studies, means reversion studies and momentum studies. The subjective studies include pattern recognition as well as support and resistance.
Trend following strategies are technical analysis strategies that analyze historical prices to determine if a financial instrument is within a trend. A trend is a specific direction and for the most part continues to go in the same direction over a period of time. The easiest and most efficient way to analyze a trend is to look at historical moving averages of a particular financial instrument. A moving average is an average where the latest days are dropped off the average calculation. In a 5 day moving average, on the 6th day, day 1 is dropped off the average calculation.
An example of analyzing a trend is as follows.
Say an investor examined the prices of the AUD/USD currency pair and the 10 day and 40 day moving averages of this currency pair, a trend can be potentially defined when the 10 day moving average crosses above or below the 40 day moving average. Moving average strategies are robust technical trading strategies and they are solid at defining trends, but on their own, they do not always generated the best entry point into the market. Most trend following strategies will create signals that are wrong more than they are correct, but the money that you make during the trend, far out ways the money that you might lose when you are wrong. An example of how this will be profitable when technical trading is as follows. If a strategy was profitable 33% or the time and unprofitable 66% of the time, but made 10 dollars on profitable trades and lost 2 dollars on unprofitable trades, the strategy would be profitable (on 6 trades – 2 winners, 4 losers – profit = 2 * 10 or 20, losses = 4 * 2 or 8 = 20 – 8 = 12) Technical trading require strong risk management techniques which provides traders the tool needed to exit the markets at the appropriate moments.
Second tool that is commonly used in trend following strategies is the moving average convergence divergence or MACD. This strategy measure momentum in the market and determines if momentum is climbing or falling. The MACD indicator measure the daily changes of the moving average and compare a short moving average change with a longer moving average change. If the changes of the short moving average are greater, the MACD will rise indicating that momentum is increasing. The reverse is the case when the MACD is falling.
Another technical strategy that is employed when trading financial markets is a mean reversion strategy. Mean reverting means that the financial instrument will fall back to its mean (average) after moving away from it over a period of time. A good analogy is to think about how far wills a rubber band stretch before it snaps back. This type of analysis would be helpful on two companies that have similar business models. For example, a trader could perform mean reversion analysis on Coke and Pepsi. A technical indicator that is used by analyst to measure mean reversion are Bollinger Bands. Bollinger Bands are a mathematical formula that calculated a specific standard deviation around a specific average.
A second group of technical indicators that are used to measure mean reversion are Relative Strength and Stochastic indicators. Both of these technical indicators measure how fast a market has moved in the short term, relative to movements over a longer period. These indicators create an index that is used by traders to determine if a market is overbought or oversold.
Another type of technical analysis is pattern recognition. In this type of analysis, the trader is looking at specific patterns within the price action to determine if he can recognize a pattern that has show s propensity to forecast a specific price move. Any example of this type of pattern is a “head and shoulders pattern”. A head and shoulder pattern forms two shoulders and a head and in general the market will fall after forming the second shoulder.
Technical analysts will also create trend line to determine support and resistance. Trend line analysis is subjective, but as a general rule, highs are connected to highs and lows are connected to lows to create a trend line.
Technical analysis is a useful study to help market participants in an effort to create a specific trading strategy, or to assist in conjunction with other types of trading strategies. The study of technical analysis will not only help in strategy formation, but it will also allow the investor to have some insight into what other market participants might be considering. This article touched on some basic ideas that can be used when beginning the process of trading. There are numerous books and articles written on both fundamental and technical analysis, and investors should take the time to examine some of these types of analysis prior to trading, in an effort to develop their trading style.