Technical analysis is one of the key elements of any successful trading plan. In fact, every professional trader incorporates at least some form of technical analysis into their strategy. But what is technical analysis? Let’s explore the concept.
Using price charts in technical analysis
To engage in technical analysis, you need to understand what a price chart is and how it works. Price charts are the foundation of technical analysis. They allow traders to analyse historical trends.
To illustrate this, we could use the example of an office desk. You cannot set up your PC, keyboard, speakers and stationery for your working day without the foundation of a desk. Once the desk is in place, you can then start laying out the tools you need to be productive.
The price chart is your ‘desk’ within a trading plan. Once you have it, you can then start to develop technical analysis. Remember, the information found on a price chart is what you will analyse in technical analysis.
Technical analysis is a visual representation of how the price of a particular currency pair has been moving. Traders look at this historical data to make predictions about future movements.Once you understand the general patterns of movement for price, you can understand how markets act at different times. This insight can be critical when it comes to finding a good entry point for your trading. It can also help with identifying the best prices to place your stop losses and take profit orders.
Once you understand the general patterns of movement for price, you can understand how markets act at different times. This insight can be critical when it comes to finding a good entry point for your trading. It can also help with identifying the best prices to place your stop losses and take profit orders.
Entry levels, stop losses & targets
Technical analysis can help identify entry levels, stop loss levels and targets. Even the smallest improvement in the accuracy of these three elements can have a significant impact on your trading.
For example, if you wanted to buy a currency pair but paid no regard to your entry, you run the risk of entering a trade at a point of resistance. Making this mistake repeatedly would chip away at your account balance, eroding your confidence.
Consider this next scenario. You are in a profitable trade, but do not have a clear plan for taking profits. You hold to try and get as many pips as you can from the move. However, you see the price fall back to your entry level, triggering your stop loss. This has the same impact on your trading psychology.
These things have nothing to do with the trade itself, but whether you manage it correctly. Technical analysis can help you identify price levels for these three elements for short-term trading.
As you’ll soon learn, technical analysis is great at providing you with reference points on a price chart.
When looking for an entry level, try entering the market close to the next point of support (buy) or resistance (sell). Your drawdown will be much lower, as the price will start moving in the direction of your trade much sooner.
You can use technical analysis to find these reference points. Keep in mind, support and resistance is a price level where the market has recently bought or sold from. Therefore, traders will closely monitor price should it hit those price levels again. These are the points at which you should enter your trades.
Essentially, technical analysis can help to get your trade moving into profit more quickly. It can also prevent you from sustaining unnecessary losses.
In particular, technical analysis can help with stop loss placement. Stop losses should be applied close to your entry level, which is determined by support and resistance levels.
This is a sound approach providing your fundamental analysis is correct. In other words, you need to be sure your price direction prediction is correct.
However, it’s important not to apply stop losses too close to your original entry level. If you do this, there’s a chance your stop loss could be triggered too early, resulting in unnecessary losses. You need to give your trade room to run.
The final area where technical analysis can help is with taking your profits. Specifically, it can help you prevent take profits at the optimum price level – maximising your profitability over any
Let’s look back at the hypothetical example of buying a pair. Your entry point would be close to the last point of support. Following this logic, we know that your optimum take profit level should be just underneath the next point of resistance.
Generally, try to resist the temptation to hold your trade in the hope that it breaks the next point of resistance – unless the fundamentals give you a clear reason to do so.
Technical analysis tools
Most trading platforms come with technical analysis indicators which you can draw over price charts. They assist in identifying the levels we have discussed above. Broadly speaking, these technical indicators fall into three categories:
- Significant price level indicators
- Trend indicators
- Momentum indicators
Within these categories, there are many indicators you may have heard of. These include: Fibonacci, Pivot Points, Price based Support & Resistance, Simple Moving Averages, Exponential Moving Averages, MACD, Stochastic Indicators and Relative Strength Index Indicators.
All of these fall into the ‘tool box’ of technical analysis indicators. These can be applied to price charts and used to assist with entries, stop loss placement and profit targets.
Technical analysis is very visual, so it’s relatively simple for new traders to grasp.
Marketers and vendors that are trying to sell products have created tools that can display ‘buy’ or ‘sell’ signals in basic colours. This is oversimplifying the process of trading – there is no such shortcut.
The entire retail trading education industry is now becoming overly reliant on technical analysis and systems. This has resulted in many retail traders using technical analysis to predict future price movements. This ‘all encompassing’ approach to trading with technical analysis is one of the main reasons retail traders fail.
Instead, technical analysis should only be used to identify past key price levels.
As a general rule, professional traders will balance out their analysis between technical and fundamental at a ratio of around 80% fundamentals and 20% technicals.
What is technical analysis?
In summary, technical analysis can help optimise your profitability – but it isn’t a substitute for fundamental analysis. For the best results, you should combine fundamental analysis and technical analysis.
I hope you’ve found this article useful. If you have any questions, please leave them in the comments below. I’ll do my best to reply to as many as I can.