What is technical analysis?

Key takeaways:

• Technical analysis uses historical price and volume data to help traders assess market conditions, possible price moves and potential entry or exit points.
• Technical analysis can be applied across markets such as equities, forex, commodities, and futures, provided there is sufficient historical data for analysis.
• Unlike fundamental analysis, technical analysis focuses mainly on price, volume, and chart patterns rather than on company accounts, valuation, or economic factors.
• Candlestick charts, support and resistance, momentum indicators, moving averages and ADX are commonly used to assess trends, volatility and market behaviour.
• Technical analysis can support a more structured trading process, but indicators can fail and should be treated as one input rather than a reliable predictor.

Technical analysis is an approach some traders use to study historical price and volume data, with the aim of forming a view on current market conditions and potential price moves. Traders who use technical analysis often apply indicators to price charts to help assess possible entry and exit points.

But no technical indicator is 100% foolproof. Trading signals can be wrong and should not be relied on in isolation. However, many traders use technical indicators to identify recurring patterns in the financial markets, while recognising that patterns can fail or change as conditions shift. It is these patterns that technical analysis traders use to form a view on potential future price movements, recognising this is uncertain.

How can technical analysis be applied?

Technical analysis can be used to assess potential price moves across many instruments, provided there is enough historical price or volume data to analyse. This brings many instruments into play, including equities, forex (foreign exchange), commodities, futures, and other financial instruments influenced by supply, demand and market sentiment. Some instruments (e.g., forex and futures) can be complex and may involve leverage, which can magnify losses.

Recurring patterns are often easier to analyse in liquid markets, where price data is more extensive, and trading costs may be lower. Forex is one example of a highly traded market, which is why some short-term traders focus on currency pairs.

In technical analysis, traders use price charts to help assess potential price moves. Chart timeframes can range from one-minute charts to daily, weekly or even yearly charts, depending on the trader’s strategy. Also, many day traders use shorter timeframes, such as five-minute, 15-minute or hourly charts.

How technical analysis differs from fundamental analysis

The main difference between technical and fundamental analysis is that fundamental analysis focuses on an asset’s underlying value based on economic, financial and business factors. Technical analysis focuses mainly on market data, such as price, volume, and chart patterns, rather than on company accounts, economic forecasts, or industry fundamentals.

Technical analysis is often used by short-term traders, although some investors also use it across longer timeframes. When we say short term, we really mean it. It could be just a few minutes or hours, rather than the days, months or even years involved with most trades underpinned by fundamental analysis.

With fundamental analysis, traders and investors often assess whether an asset appears undervalued or overvalued based on its fundamentals, while recognising that prices may not realign quickly or at all. Meanwhile, technical analysis is often used by day traders who open and close positions within the same day, but it can also be used by swing traders and longer-term market participants.

While technical analysis looks exclusively at price movements and market psychology, fundamental analysis weighs up external information including the broader economic outlook of a relevant industry, competitor performance and other industry trends.

In summary, technical analysis uses historical market data to form a view on possible future price behaviour. Fundamental analysis looks at factors such as financial performance, valuation, industry conditions, economic outlook, news and company announcements.

Understanding trading candlesticks

Candlestick charts are the most common type of chart used in technical analysis. Candlesticks are the chart ‘bars’ used to denote the price movement of an instrument within a set timeframe. For example, when using an hourly chart, every candlestick displayed demonstrates the price action in the market for every hour. Similarly, one-minute charts will display candlesticks showing the price action in the market every 60 seconds.

Candlesticks are ‘formed’ on a chart based on the price action. The top of a candlestick is used to denote the highest price an asset was traded during the selected timeframe. The lowest point of a candlestick denotes the lowest price an asset was traded during the same period.

Each candlestick has a ‘body’. This is the thick part that’s either green (bullish) or red (bearish). The body is designed to replicate the opening and closing price of an asset over the selected timeframe. Green is commonly used for candlesticks that display a positive price move for an asset, while red is commonly used for candlesticks showing a decline in an asset’s value over a set period. However, the colour choice is an arbitrary decision. Depending on your choice of trading software, it may be that the candlesticks are white and black instead, or even blue and yellow. Either way, trading candlesticks are one of the quickest ways to understand whether a price closed higher or lower at the end of a selected timeframe.

Some retail traders believe that candlesticks tell the bigger picture of an asset than a basic line or bar chart. That’s because a candlestick shows the highest and lowest price of an asset during a set timeframe to showcase its recent volatility.

The most popular technical analysis indicators

If you’re just starting out in financial trading and you’d like to learn more about technical analysis, read on as we explore some of the common technical indicators that retail traders use to interpret trends.

Support and resistance levels

Support and resistance are price areas that traders use to assess where buying or selling interest has appeared in the past. Support is an area where buying interest has previously helped slow or reverse a decline, while resistance is an area where selling interest has previously slowed or reversed a rise.

A move near support or resistance can influence trader behaviour, but these levels can break and do not reliably mark the start of a new trend. Some day traders watch how price behaves near support or resistance before deciding whether it supports their broader trading plan.

Trend momentum

If you are a trader that likes to follow market trends, you’ll want a technical indicator that enables you to measure the strength of a trend. There are a few popular indicators for momentum. Rate of Change (ROC) measures how much an asset’s price has changed over a selected timeframe. Welles Wilder, one of the pioneers of technical analysis in the 20th century, devised the Relative Strength Index (RSI) as a momentum indicator. It is a momentum oscillator that compares the magnitude of recent gains and losses to indicate momentum. A higher RSI reading generally indicates stronger recent upward price momentum, while a lower reading generally indicates stronger recent downward momentum. RSI signals are commonly interpreted in context and are not reliable on their own.

There’s also the Moving Average Convergence Divergence (MACD) indicator that’s equally popular today for momentum. MACD is commonly used to assess momentum via relationships between moving averages (for example, crossovers and changes in the histogram). Signals can be interpreted in different ways and are not reliable on their own.

Simple moving averages (SMAs)

An SMA is the most basic version of a moving average and is a starting point for novice traders before graduating to a MACD indicator. An SMA adds up the closing prices of an asset over a set period and divides it by the number of minutes, hours, days or months you want.

Let’s say you want to calculate the SMA of an asset over a 20-day period. You would add up the closing price each day divide the final sum by 20. You then have the average closing price for the last 20 days. By plotting this each day over time, the simple average will move with the price and can be used, for example, to eliminate some of the noise of day-to-day movements and better show the underlying trend.