What is technical analysis?

Technical and Fundamental Analysis are the two most common ways of performing research on any trading vehicle (incl. stocks, commodities, currencies, ETFs). Traders use these tools to evaluate investments and spot trends, which indicate good opportunities for trading.

Fundamental analysis tries to weigh all the information in a given market (such as company financials, the general economic environment, global and domestic, competitors, how the interest rates are moving, and others). On the other hand, technical analysis assumes the price of the security has already reflected all available information.

We base this kind of analysis on historical data and statistical trends in price. In some cases, the volume movements of trading instruments also play a role. In other words, technical analysis uses the notion of supply and demand forces to predict future investment opportunities.

Traders prefer to use technical analysis to focus more on short-term movements. This is why it is most commonly applied in the commodity and currency markets to generate signals of profitable investments. However, we can use the same concepts and techniques to any other financial security with available historical trading data. Technical analysis is also helpful to assess the strengths and weaknesses of a trading instrument compared to others in the same sector or even the broad market.

Underlying assumptions

Technical analysis originates from Charles Dow’s Theory dating back to the late 19th century. Contributions from other notable researchers helped shape the basis of Dow Theory. Today, we use numerous signals and patterns developed over time as indicators of good trading opportunities. Dow’s Theory includes two underlying assumptions in technical analysis:

• Markets are efficient;
• Price patterns tend to repeat over time.

Nowadays, with the continuation of extensive research, analysts are guided by three general assumptions:

• All available information is already reflected in the price of a trading instrument. Having this in mind, a supply and demand analysis of a given security should provide enough information to support investment strategies;
• Price movements of any given security occur in patterns. Trading strategies, which imply technical analysis, rely on this notion;
• History, in general, repeats itself. We assign price movement patterns mainly to market psychology, or in other words, emotions also tend to be predictable. Researchers and analysts use different patterns (chart, candlestick, breakout, and others) to predict future market movements and spot trends.

Critiques of these assumptions include the notion that historical data does not contain enough actionable information. Another criticism is that we cannot rely on price patterns. The idea is that these patterns are not clear and specific enough, and we should instead treat them as random walks.

Moreover, even if price movements show a clear trend, this is mainly due to the more significant number of investors placing stop-loss orders (based on technical analysis) and thus confirming the price movements expected from the analysis.

Advantages and disadvantages

As any method in the financial field, technical analysis has some pros and cons.

• Advantages:
  • Clarity: Charts provide a clear picture of, for example, price movements. Technical analysis helps to obtain helpful information quickly.
  • Objectivity: Technical analysis uses historical (objective) prices and volumes.
  • Patterns: Patterns can be easily spotted with charts and used as guidance for investment decisions.
  • Inexpensive: With the help of computers, we do not require many resources (time or money-wise) to perform technical analysis.

• Disadvantages:
  • Short-term: Technical analysis does not focus on the company’s financials and other underlying fundamentals, which, in the long-term, may need to be considered to avoid risk.
  • Contradictory: Using different indicators may give ambiguous or even conflicting results.
  • Bias: With the involvement of people in the process, technical analysis becomes susceptible to individual preferences and prejudices, which may result in unprofitable trading.

Charts

There are many different types of charts that technical analysts use in their research. The most basic one is the Line Chart, which helps visualize a security’s price movement in a given period.

This type of chart shows only the closing prices, which reduces the noise from movements (open, high, low) during the trading day. Because of this, line charts are one of the more preferred instruments to use, as closing prices are the most common historical data viewed by traders.

Another tool traders and analysts frequently use is a Bar Chart. This chart usually consists of four (can be adjusted to three) separate bars for open, high, low, and closing prices (more commonly only high, low and close). It illustrates the price movement of a given security over a period.

There are also vertical and horizontal lines representing high/low and open/close prices, respectively.

Candlestick Charts are another type of chart used by technical analysts. Candlesticks are similar to bars, and traders prefer them for being more visual, mainly because of color coding and thicker bar bodies that clearly show the difference between open and close prices.

One more tool, which analysts prefer is the Point and Figure Chart. This chart is significantly different from those mentioned above, mainly because it represents the price rather than the price and time frame. It visualizes the data (price) as X’s and O’s (blue and red marks).

We use X’s to illustrate if the price rises more than a specified amount and O’s to indicate a fall by more than a certain amount. We mark consecutive indicators in the same column, and if the price movement reverses, we move to the next column to the right. Excel does not support Point and Figure charts natively, but you can use add-ins to generate them automatically.

Example

Let us look at the Ethereum – USD daily prices for two weeks (2^nd June 2021 – 16^th June 2021).

First, we start with a summary of what the green and red candlesticks tell us.

A green candlestick means that the closing price for the time frame was higher than the opening price. With the red candlestick, it is the other way round. The vertical lines (also knows as wicks) show the highest and lowest price for the time frame. The distance between the high and the low is called range.

Different types of patterns can serve as an entry trigger for your investments. In the picture from the example, we can see a Bearish Engulfing pattern, which means that in the first period, there was substantial buyers control and drove the price up. However, the price dropped even further in the second period than the opening price in the previous period (the previous candlestick is engulfed).

One more pattern we can look at in the example is the candlestick between the 8^th and 9^th June, where the wick is relatively more prominent than the candlestick’s body. In our example, we can see a Shooting Star pattern between 8^th and 9^th June, which means there was strong price rejection from the market, and the price went down. These patterns combined with indicators, which use historical data and apply formulas to it (e.g., moving average), can be very helpful as entry triggers and for understanding the market conditions.

Now, let us look at some patterns that indicate whether the price will go up (buyers are in control) or down (sellers have the control). If we look at the period between 2^nd and 4^th June, we can see a Bearish Engulfing Pattern. Here the prices rise in the beginning and then drop, engulfing the price increase from the previous day.

We can also see that the lowest point on 4^th June is way lower than the previous day open. This means that the sellers now have control, and prices are expected to drop even further. We can see that the price on 5^th June is even lower. The Bearish Engulfing Pattern is a sign you have to either sell or short the financial instrument.

Another pattern we can spot in the graph occurs in the period between 10^th and 12^th June. Here we can see the exact opposite of what we discussed above. It is called a Bullish Engulfing Pattern. If we look at the first two candlesticks, they show a decline in prices. However, on 12^th June, we can see the prices rising once again, and if we look more closely, we see that the high of the day is close to the opening price of the previous day (before it declined).

This indicates that the buyers are taking control back and would probably increase the price even more in the next period. On 13th and 14th June, we can see the prices went up almost to the levels before the decline. The Bullish Engulfing Pattern indicates that it is a good idea to buy.

Conclusion

Technical Analysis is a practical and robust method that traders use to predict short-term price movements. It uses charts to visualize the information clearly and easy-to-read while utilizing objective (historical) data. Moreover, it is also inexpensive to perform such analysis with the use of computers, which makes it a must when considering investments.

Many critics of the method claim that the technical analysis does not provide actionable information and that the patterns visualized by the analysis are somewhat dubious. It is important to remember that technical analysis does not provide 100% accurate signals to follow. We need to combine it with additional research to minimize risk and optimize returns.

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