Intermediate

Technical analysis

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Understanding technical analysis

4-minute read

Some traders define themselves by how they find their opportunities. In this course, we’re going to cover one of the most popular methods – technical analysis.

What is technical analysis?

Technical analysis is a method of identifying trading opportunities that relies on reading price charts. Technical traders use these charts to determine the future direction of a market, as well as possible entry and exit points for each position.

To view a technical chart, log in to your FOREX.com demo and hit the name of any market. Some traders also use independent charting software, such as Metatrader.

Technicals vs fundamentals

Technical analysis is one of the two main ways in which traders analyse the markets; the other is fundamental analysis. They represent very different methods for assessing assets and finding new positions.

  • Technical analysis involves looking purely at market prices and patterns, ignoring all other data
  • Fundamental analysis involves researching what is driving market price action, taking earnings, economic data and more into account

You can use either approach in isolation, or a mixture of the two. Many traders, for example, will use fundamentals to find underpriced markets – then use technical analysis to plan exactly when to enter and exit their position. At each extreme, though, there are those who use pure technical analysis and others who are solely fundamental traders.

We’ll cover fundamentals in more detail in the Fundamental analysis course.

In recent years, new methods of researching the markets have begun to gain traction, such as sentiment and statistical analysis. But for now, most traders stick to one of the main two methods.

Analysis types defintions

The basis of technical analysis

No trader has a crystal ball that they can use to see what will happen next in the markets. Instead, they use available information to make an educated guess about the future price action of their chosen asset and then weigh up the risk against the potential reward from the resulting trade.

Purely technical traders believe they can find all the information they need to determine the future direction of a market within its price chart.

Order in the chaos

The basis of technical analysis comes partly from Chaos Theory – the hypothesis that identifiable patterns will repeat in even the most chaotic-seeming areas. Instead of making concrete assertions about market behaviour, technical traders use these patterns to determine the probability of a certain move.

Based on this probability, they can decide whether a trade is worth the risk.

To technical traders, a price chart gives an insight into the markets’ general sentiment on a given instrument. By combining that with what has happened previously, they decide on its future direction.

Say, for example, that a strong S&P 500 rally is followed by a period of consolidation. A technical trader might see this as evidence that the positive sentiment on the market is waning. If this pattern has shown a tendency to lead to price reversals in the past, then they might see that as a chance to open a short position.

Benefits of technical analysis

One of the main advantages of technical analysis is that it is considered as a neutral tool. You can apply it to virtually any instrument over any timeframe, and it doesn’t rely on an analyst’s forecast. Whether you’re scalping forex or investing in stocks, you can make use of technical analysis to find and plan trades.

It can also provide an excellent method of determining your entry and exit points for a position.

As we’ve seen in earlier courses, markets rarely move in a straight line. Instead, they’ll zigzag – either sideways, upwards or downwards. If you can use technical analysis to time your trades within these zigzags, then you’ll be able to push profits a little bit further

Examples of price movement on a chart

Or, even better, you might be able to use technical analysis to spot when overall sentiment on a market is reversing.

Drawbacks of technical analysis

Because it relies solely on price charts, technical analysis only looks at what has happened in the past when predicting what might happen in the future.

But just because something has happened before, it doesn’t mean that it will reoccur – the factors surrounding a pattern may be different this time, or an external event might impact the markets in a wholly unpredictable way.

A pure technical trader, for example, might see their position adversely affected by some poor employment data that sends markets plummeting. A fundamental analyst, meanwhile, would have paid more attention to this external price driver.

There is no single ‘magic’ approach to the markets that will always yield results. The secret of successful trading is good risk management, discipline, and the ability to control your emotions.

Key concepts

There are hundreds of tools that a technical trader can utilise. But it all boils down to identifying support and resistance, trends and ranges.

Support and resistance

Support and resistance are areas on a market’s chart that it has difficulty breaking past. If a market reaches its support or resistance level, then a price reversal may be on the cards.

Trends and ranges

Markets can only be in three states:

  • An uptrend, when prices are rising overall
  • A downtrend, when prices are falling overall
  • A range, when prices are stuck between support and resistance

By using indicators and patterns, technical traders aim to spot when new trends are forming.

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Test your knowledge

Question 1 of 3
You trade by finding stocks that you think are underpriced, examining their earnings reports and other external data to make a decision. Are you a:
  • A Technical trader
  • B Fundamental trader
  • C Both
  • D Neither
Question 2 of 3
You day trade forex, constantly monitoring the charts of a handful of pairs on the lookout for new trends. Are you a:
  • A Technical trader
  • B Fundamental trader
  • C Both
  • D Neither
Question 3 of 3
You use a few sources to find potential markets to trade, then use charting tools to plan your exact strategy. Are you a:
  • A Technical trader
  • B Fundamental trader
  • C Both
  • D Neither