Technical analysis (TA) is a type of analysis that allows you to predict market behavior based on previous price dynamics and trading volume data. The TA approach is widely applied to stocks and other assets in traditional financial markets, but is also an integral component of digital currency trading in the cryptocurrency market.
Unlike fundamental analysis (FA), which takes into account many factors related to the price of an asset, TA is strictly focused on historical price dynamics. As such, it is used as a tool to study price movements and volume data for an asset, and many traders use it in an attempt to identify trends and favorable trading opportunities.
The first forms of technical analysis appeared in the 17th century in Amsterdam and in the 18th century in Japan, but modern analysis is associated with the work of financial journalist and founder of The Wall Street Journal, Charles Dow. Dow was one of the first to notice that individual assets and markets often follow certain trends that can be segmented and explored. His work later gave rise to the Dow Theory, which contributed to the further development of technical analysis.
In the early stages, technical analysis was based on handwritten tables and calculations by hand, and as technology developed, it became widespread. It is now an essential tool for many investors and traders.
How does technical analysis work?
As already mentioned, TA is mainly a study of the current and previous prices of an asset. The basic assumption underlying technical analysis is that price movements of an asset are not random and usually turn into identifiable trends over time.
At its core, TA is an analysis of the market forces of supply and demand that reflect the general mood of the market. In other words, the price of an asset is a reflection of opposing buying and selling forces, and these forces are closely related to the emotions of traders and investors (essentially fear and greed).
Technical analysis is considered most effective for researching markets with high trading volume and liquidity that operate under normal conditions. Markets with large volumes are less prone to price manipulation and anomalous external influences that can create false signals and nullify TA results.
To examine prices and ultimately identify favorable opportunities, traders use various charting tools known as indicators. Technical analysis indicators can help traders identify existing trends, as well as provide useful information about future trends. Because TA indicators are volatile, some traders use multiple indicators to reduce risk.
Conventional TA indicators
Typically, traders who use TA also use a variety of different indicators and metrics to try to identify market trends based on charts and price movements. Among the many technical analysis indicators, simple moving averages (SMA) are one of the most commonly used and well-known examples. As the name suggests, the SMA is calculated based on the closing prices of an asset over a set time period. The Exponential Moving Average (EMA) is a modified version of the SMA in which recent closing prices are weighted more heavily than old ones.
Another popular indicator is the relative strength index (RSI), which is part of a class of indicators known as oscillators. Unlike simple moving averages, which simply track price changes over time, oscillators apply mathematical formulas to price data and then produce readings that fall within specified ranges. In the case of RSI, this range varies from 0 to 100.
The Bollinger Bands (BB) indicator is another type of oscillator that is quite popular among traders. The BB indicator consists of two lateral lines that flow around the moving average line. It is used to identify potential overbought and oversold markets, and even to measure market volatility.
In addition to simple technical analysis tools, there are indicators that generate data based on other indicators. For example, the stochastic RSI is calculated by applying a mathematical formula to the regular RSI. Another popular example is the Moving Average Convergence/Divergence (MACD) indicator. The MACD is generated by subtracting the two EMAs to create the main line (the MACD line). The first line is used to construct another EMA, resulting in a signal line. Additionally, there is a MACD histogram which is calculated based on the difference between these two lines.
Trading signals
While indicators are useful for identifying general trends, they can also be used to provide information on potential entry and exit points (buy or sell signals). These signals can be generated when certain events occur on the indicator chart. For example, when the RSI gives a value of 70 or more, it may indicate that the market is operating in an overbought condition. The same logic applies when the RSI drops to 30 or below, which is usually taken as a signal that the market is oversold.
As discussed earlier, the trading signals provided by technical analysis are not always accurate and there is a significant amount of noise (false signals) generated by TA indicators. This is especially true of cryptocurrency markets, which are much smaller than traditional markets and, as such, more volatile.
Criticism
Although TA is widely used in various markets, it seems to many professionals to be a controversial and unreliable method, and it is often called a "self-fulfilling prophecy". This term is used to describe events that occur only because many people assumed they would.
Critics argue that in the context of financial markets, if a large number of traders and investors rely on the same types of indicators, such as support or resistance lines, the chances that these indicators will work increase.
On the other hand, many proponents of TA argue that each proponent of charts has a special way of analyzing them and using the multitude of available indicators. This would mean that it would be virtually impossible for a large number of traders to use the same specific strategy.
Fundamental analysis vs. technical analysis
The basic premise of technical analysis is that market prices reflect all the fundamental factors associated with a particular asset. But unlike the TA approach, which is primarily focused on historical price and volume data (market charts), fundamental analysis (FA) uses a broader research strategy that pays more attention to qualitative factors.
Фундаментальний аналіз вважає, що майбутня ефективність активу залежить від набагато більшого, ніж просто історичних даних. По суті, ФА – це метод, який використовується для оцінки внутрішньої вартості компанії, бізнесу чи активу на основі широкого спектру мікро- та макроекономічних умов, таких як управління компанією та її репутація, ринкова конкуренція, темпи зростання та стан галузі.
Therefore, we can consider that unlike TA, which is mainly used as a tool for predicting price dynamics and market behavior, FA is a method of determining whether an asset is overvalued or not, depending on its context and potential. While technical analysis is mainly used by short-term traders, fundamental analysis is usually chosen by fund managers and long-term investors.
One notable advantage of technical analysis is that it relies on quantitative data. As such, it provides a framework for an objective study of price history, removing some of the assumptions associated with a more qualitative approach to fundamental analysis.
However, despite working with empirical data, TA is still influenced by personal biases and subjectivity. For example, a trader who is highly biased towards a certain conclusion about an asset is likely to be able to manipulate their TA instruments to confirm their bias and reflect their perceptions, often unconsciously. Moreover, technical analysis can also fail during periods when the markets do not show a clear pattern or trend.
Results
Apart from the criticisms and long-standing disputes about which method is better, a combination of TA and FA approaches is considered by many to be the more rational choice. While FA usually refers to long-term investment strategies, TA can provide useful information about short-term market conditions that can be useful for both traders and investors (for example, when trying to identify favorable entry and exit points).