Key Points
- What is Technical Analysis?
- The uses of Technical Analysis
- Common Tools
- Limitations
What is Technical Analysis
Technical analysis is a core aspect of retail trading. In its most basic sense, technical analysis is the use of historical prices to anticipate future price movements. Every self-trader knows and uses some sort of technical analysis in their trading.
On the other hand, fundamental analysis focuses on macroeconomic developments and how they can impact the true value of a particular asset.
Technical analysis, although reliable, is not the holy grail of trading. It is not foolproof but it certainly does equip traders with the edge to excel in the markets.
The Uses of Technical Analysis
1. Identifying market structure
Determine if the market is trending upwards, trending downwards, or going nowhere at all.
2. Signals for entries and exits
Example 1:
There were multiple bounces when the price was at $1888 before. I then draw a support line at $1888 and wait patiently for the price to come here again. I will place a buy order in anticipation of another price bounce.
Example 2:
I marked a resistance level at $1921 because the price respected that level before as marked by the blue circles. Stop loss is marked at a resistance level created by a previous swing high while TP is at the previous support level @1883.
Well, the trade didn’t work out but we prepared for both outcomes by setting SL and TP with the help of support and resistance (Technical analysis)
3. Confluences
Confluence means additional supporting factors for our trade idea. Referring to the image above, I had a sell position at 1921 resistance. One of the confluence that backed my idea of a short position is the massive bearish momentum leading up to the consolidation (the red candles that look like a waterfall on the left side of the chart).
Common Technical Analysis Tools
1. Support and resistance
Support and resistance is the most basic technical analysis tool ever. They are literally everywhere, from online articles and forums to group chats and webinars. It is a simple way to gauge the key levels of a particular security.
APEUSDT
Where to draw support and resistance?
It is subjective. There is no right or wrong support and resistance but the most general way of plotting support and resistance is to look for price levels where there were a lot of actions in the past. In the chart above, my resistance is at the $6.50 area while support is at the $6.00 area. Notice it is not a price line but instead a zone to accommodate price volatility.
Why do they work? Why do they not work?
Let’s take support as an example. Support is where there was a lot of buying taking place in the past, indicating the presence of buyers in this area. We plot a support zone, anticipating that there will still be buyers/demand if the price falls to that level again.
Support works. If everyone is buying at support, the demand increases, raising the price of the security. Support also doesn’t work because everyone is buying at support. What is this contradiction?
If you are a seasoned trader, you would have experienced or noticed fakeouts taking place frequently at these key support and resistance areas.
Let’s refer to the chart of APEUSDT again. Notice the candles circled in red. What is the implication of this particular price movement?
- Those who are long at the support area will have their stop losses triggered
- Breakout traders (those who place trades in the direction of the breakout) will initiate their sell positions
These two groups of traders are losing money because of this fakeout.
2. Trendlines
Trendlines are just sloping lines that are drawn to connect consecutive swing highs and/or swing lows.
APEUSDT H1
See how we connect the higher lows marked with arrows to form a bullish trendline?
Channel
APEUSDT H1
Trendline + Trendline = Channel
A channel is a formation created by two parallel trendlines. In the chart above, a bullish channel is formed by drawing 2 parallel bullish trendlines.
I have also placed a demo short position because I am anticipating the price to respect the channel and retreat back down into the channel. My stop loss (SL) is just above the candle high and the lower trendline is where I placed my take profit (TP).
What if the two trendlines are not parallel to each other?
Triangles
APEUSDT H1
Trendline + Trendline = Triangle
The chart above shows two trendlines converging into one another, forming what we call a “triangle” formation. If you see this pattern on a chart, it implies that the market is getting “squeezed” and ready for a breakout on either side of the triangle. However, be careful as there could be fakeouts before the real move takes place and it is beautifully depicted in the chart above.
3. Market Structure
There are 3 types of market structure
- Consolidation
- Uptrend
- Downtrend
A. Consolidation / Ranging markets (No trend)
The market is said to be consolidating when the price is trading between two defined price levels, ie: the support and resistance levels. Range trading strategy works best in these conditions. Simply buy when the price hits the lower boundary (support) and sell when the price hits the upper boundary (resistance)
B. Downtrend
A downtrend can be characterized by lower highs and lower lows. We can notice a stronger bearish strength relative to the buy-side where the price is pushed down lower in each subsequent price swing.
C. Uptrend
The opposite of a downtrend. We can observe higher highs and higher lows in an uptrend.
A common saying in the retail trading industry is “the trend is your friend”. It is cliche but true to a certain extent. The best advice is to go with the trend and not trade against it as the probability of making profits is lower and the profit potential is smaller (ie: the market is only going to retrace that much before it resumes its trend)
The Bigger Picture
If we zoom out and take in a wider view, we will see the market experiencing a mixture of different market structures. Initially, the market is forming a triangle pattern (more specifically an ascending triangle). After breaking out from the triangle, the price is seen to be consolidating in a very narrow range, followed by a breakout to the upside again (and hence the advice earlier to not trade against the trend). Then, the price continued to make higher highs and higher lows, signaling an uptrend.
4. Chart patterns
As price moves across the chart, they form recognizable patterns, and here are some of the most common ones; Price patterns can signal either a price reversal or a continuation in the current direction.
Triple Bottom on GBPUSD M15
Double Bottom on EURJPY M15
Head and Shoulders on EURJPY M15
5. Technical Indicators
How can we forget about Indicators when we are talking about technical analysis? Those that we discussed earlier can be categorized as “price action” because we only look at what the price and candlesticks did in the past.
So what are technical indicators?
Technical Indicators in a nutshell – take in historical price data, dump them into a formula, and churn out numbers which are then presented visually as lines/ clouds/ etc.
I am not going to explain much about the different technical indicators because there are thousands of them out there, if not more. Not only that, but retail traders have moved on from relying on technical indicators to a more price-action-based approach (based on my personal observations)
Read more about technical indicators here:
Benefits and Limitations
Benefits
- Provide a framework for traders to time the market for entry and exit points.
- It is objective. Traders’ subjective opinions are not likely going to affect the reading of technical analysis. For instance, if there is a moving average crossover on EURUSD M15, there is a moving average crossover on EURUSD M15, regardless if the trader admits it or not.
- Consistency. Technical analyses, especially those based on indicators are formulated by mathematics. There are solid statistics of how the technical strategy performed historically and traders can make decisions based on those data.
Limitations
- Technical analysis is not a crystal ball that can predict the future. Traders may mistakenly believe that a desirable outcome is assured and when the reality does not match their expectations, it may lead to destructive emotional behaviors.
- No fundamentals input. Technical analysis is based purely on charts and past price data. We need to account for the latest macroeconomic trends as they heavily influence the outlook and movements of the pairs that you are trading.
Ending Thoughts
While technical analysis is actionable and practical, I have to stress this again- it does not guarantee a certain outcome just because you see a perfect signal.
With great risk-to-reward ratio, even a win rate lower than 50% can generate consistent profits over time but this concept is hard to grasp for most.
Trading is life-long learning and self-development, and we are here to support you with an abundance of resources along the way.
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