The inception of technical analysis can be traced way back to the late 1800s when Charles Dow initiated the concept. As it grew through the years, diverse researchers from William P. Hamilton to Edson Gould, made significant contributions to the concept.
In simple terms, technical analysis can be described as the use of historical trends to predict the future of financial assets. Technical analysis allows you plot prices on the chart, identify trends and patterns that are springing up recurrently, and make an objective decision to buy or sell based on the market trends.
Before we go into dissecting technical analysis, let’s take a quick look at the various assumptions upon which technical analysis is built.
- The Market Discounts Everything
The technical analyst believes that the market mirrors any external factor that could impact price. These factors could be fundamental, sentimental, psychological or political.
There’s a belief that when prices go up, it must be a result of demand (buy) being higher than the supply (sell). Whereas, when prices are going down, it must be because supply (sell) is higher than demand (buy). They do not allude to the reason for these trends to anything other than what can be seen in the market. Thus, it is believed that studying the trend of price in the market as represented on charts is all that’s required.
- History Repeats Itself
Technical analysis is founded on patterns. There is an underlying belief that when something happens over and over again, there’s a high probability that it would repeat itself.
So, what technical analysis does is that it finds the patterns in the history of price data and substantiates the movement of the market based on this.
- Prices Move in Trends
Technical analysis is largely about identifying trends. The goal is to take note of a rising trend and make investment decisions based on those trends. Behind this is the underlying belief that prices move in trends. As a result, existing trends are followed until signs of reversal spring up.
Many people like technical analysis because it removes the subjectivity and guesswork as it is based on normal math probability. They can guess the future movement of the market by looking at historical data.
Now that we have the assumptions out of the way, let’s delve a little deeper into the nitty-gritty of this concept.
To predict the future of financial assets using this technique, technical analysts observe indicators such as price trends, chart patterns, volume and momentum indicators, oscillators, moving averages as well as support and resistance levels.
It’s important we begin by establishing that there are diverse methods that have been introduced by researchers to support technical analysis. These systems are called technical indicators. Some of the most popular ones are:
- Moving average
- Bollinger Bands
- Moving Average Convergence Divergence (MACD)
This is one of the most commonly used technical indicators. A moving average helps you identify trends on the chart. You can spot an uptrend when price action stays over the moving average. And, you can spot a downtrend when price action stays under the moving average. There are several examples moving averages which include, simple moving average (SMA), weighted moving average (WMA) and exponential moving average (EMA).
Oscillators (Overbought and Oversold Situations)
In simple terms, oscillators are indicators used to recognize short-term overbought and oversold situations. An overbought situation is a situation where a financial asset is being bought and sold for more than what financial analysts believe is its intrinsic value. On the other hand, oversold which is the opposite of overbought, is a situation where a financial asset is being bought and sold for less than its intrinsic value.
This mostly occurs for a short period of time. But, whenever this happens, analysts believe that the short pattern would be corrected independently by the market. Some of the most popular oscillators are the Relative Strength Index (RSI) and the Stochastic oscillator.
Relative Strength Index (RSI)
The RSI was created by J. Welles Wilder in 1978. RSI is one of the most popular oscillators used in technical analysis. It is used to measure price movement. It also measures the strength of the current price and weighs it against the previous price. When above 70%, the RSI is considered to be overbought. But, when below 30%, the RSI is considered to be oversold.
You can learn more about how RSI is calculated here.
Sometime in the 1950s, the scholastic indicator was created. Like the RSI, it was developed to produce overbought and oversold signals in the market. But, unlike the RSI, it focused more on momentum instead of absolute price. When readings exceed 80, they are deemed oversold.
Although it can be tweaked to meet certain analytical needs, the standard time period used is 14 days. To calculate stochastic oscillator, minus the low for the period from the current closing price. Then, divide that by the total range for the period and multiply by 100.
The stochastic oscillator shows the consistency with which price closes near its recent high or low. It achieves this by comparing the current price to the range over time.
A technical trader called John Bollinger created this technical analysis tool, hence, the name. This tool simply uses a system where a moving average with two bands above and below it is used.
The Bolinger Band is made up of three lines – a simple moving average or middle band, an upper and a lower band. What majority of traders believe is that the closer the prices move to the upper band, the more overbought the market. Similarly, the closer the prices move to the lower band, the more oversold the market.
Moving Average Convergence Divergence (MACD)
The MACD indicator offers both trend following and momentum. It was created in the 70s by Gerald Appel. It simply transforms two moving averages to a momentum oscillator. It achieves this by taking away the longer moving average from the shorter moving average.
MACD is the oscillator.
The MACD indicator was originally created for the stock market to reveal variations in the strength, direction, momentum and duration of a trend in a stock’s price. To calculate the MACD, simply minus the 26-period Exponential Moving Average (EMA) from the 12-period Exponential Moving Average.