Technical Analysis – A Beginner’s Guide

What is Technical Analysis?

Using market data, technical analysis is used to predict the future price movement of a security, such as a stock or currency pair.

Technical analysis is based on the idea that the collective actions - buying and selling - of all participants in the market accurately reflect all relevant information about a traded security, and therefore, assign a fair market value to that security continuously.

Past Price as an Indicator of Future Performance

According to technical traders, the most reliable indicator of future price action is current or past price action in the market.

Technical analysis is not used exclusively by traders. Many fundamental traders use fundamental analysis to determine whether to buy into a market, and then use technical analysis to pinpoint good, low-risk buy entry prices.

Charting on Different Time Frames

Price charts are used by technical traders to forecast price movements. A trader's choice of technical indicators and the time frame considered are the two primary variables of technical analysis.

A technical analysis chart can show time frames ranging from a minute or two to a month or a year. Technical analysts commonly examine the following time frames:

• 5-minute chart
• 15-minute chart
• Hourly chart
• 4-hour chart
• Daily chart

A trader's trading style typically determines the time frame he or she studies. Most intra-day traders analyze price movement on shorter timeframe charts, such as the 5-minute and 15-minute charts, in order to open and close positions in the same trading day. Traders who hold market positions overnight and for long periods of time are more likely to analyze markets using hourly, 4-hour, daily, and even weekly charts.

Within a 15-minute period, price movement may be significant for an intra-day trader who is looking for a way to profit from price fluctuations occurring during a single day of trading. On a daily or weekly chart, that same price movement, however, may not be as significant or indicative for long-term trading.

A simple way to illustrate this is to compare the same price action on different time frames. For the past several months, silver has been trading within a range of roughly $16 to $18.50 on the daily chart. Because the price of silver is very close to the low of this range, a long-term silver investor might consider buying silver.

However, an hourly chart of the same price movement (below) shows a steady downtrend that has accelerated recently. If a silver investor only wanted to make intra-day trades, he or she would probably refrain from buying the precious metal based on hourly chart price action.

 Candlesticks

Charts showing price movement most commonly use candlestick charts. Candlesticks are formed by the price movement during a single time period within any time frame. Candlesticks on an hourly chart show the price action for one hour, whereas candlesticks on a 4-hour chart show the price action for each 4-hour period.

The highest point of a candlestick indicates the highest price a security traded at during that time period, and the lowest point indicates the lowest price during that time period. According to the charts above, the body of the candlestick (the red or blue "blocks" or thicker parts of each candlestick) indicates the opening and closing prices for the time period. An opening price higher than the closing price is indicated by a blue candlestick body; conversely, if a red candlestick body is formed, then the closing price is higher than the opening price.

It is not critical what color a candlestick body is. Some traders use white and black candlestick bodies (this is the standard color format, and thus the most popular); other traders may use green and red, or blue and yellow. Regardless of the colors used, they make it easy to determine whether prices closed higher or lower at the end of a given period. Candlestick charts make technical analysis easier than standard bar charts, because analysts receive more visual cues and patterns.

Candlestick Patterns – Dojis

Candlestick patterns, which can be formed either by a single candlestick or by a succession of two or three candlesticks, are widely used in technical analysis to identify possible market reversals or trend changes.

Candlesticks with doji patterns, for example, indicate indecision in a market that may indicate a trend change or a market reversal. A doji candlestick has the singular characteristic that the opening and closing prices are the same, so that the body is flat. A longer upper and/or lower shadow, or "tail", on a doji candlestick - the portion of the candlestick that indicates the low-to-high range for the time period - is a stronger indication of market indecision and a potential reversal.

Each of the doji candlestick variations has its own distinctive name, as shown in the illustration below.

In a typical doji, the price extends roughly equally in each direction, opening and closing in the middle of the price range. Candlesticks are a clear indicator of market indecision. After a prolonged uptrend or downtrend in a market, dojis like this are often interpreted as reversal signals. After a prolonged downtrend, a dragonfly doji signals possible upside reversal. Price action explains the logical interpretation of a dragonfly doji. During a dragonfly chart, price is significantly pushed lower by sellers (the long tail), but at the end of the period, price recovers to reach its highest point. Candlesticks usually indicate a rejection of a long decline.

The name of the gravestone doji implies that it represents bad news for buyers. By contrast, a gravestone doji indicates the rejection of any attempt to force market prices higher, which implies a potential downside reversal.

A four-priced doji, in which the market opens, closes, and all transactions are conducted at the same price over a period of time, is the epitome of indecision, a market with no discernible direction.

Candlestick patterns are available in dozens of variations, as well. Thomas Bulkowski's candlestick pattern website is probably the best resource for identifying and utilizing candlestick patterns. In addition to explaining each candlestick pattern, the site offers statistics on how often the patterns have historically provided a reliable trading signal. Knowing what a candlestick pattern means can certainly be useful, but knowing whether it is accurate 80 percent of the time is even more valuable.

Technical Indicators – Moving Averages

Technical traders can use candlestick formations in addition to technical indicators to make trading decisions.

Moving averages are one of the more popular technical indicators. Moving averages are used in a number of trading strategies. Moving average trading strategy might be something like, "Buy whenever the price remains above the 50-period exponential moving average (EMA); Sell whenever the price remains below the 50 EMA".

Other technical indicators include crossovers of moving averages. In a crossover trading strategy, you might buy when the 10-period moving average crosses above the 50-period moving average.

Price movements relative to a moving average are considered more significant the higher they are. It is generally considered more significant to cross a 100- or 200-period moving average than to cross a 5-period moving average.

Pivots and Fibonacci numbers are technical indicators

Traders often use daily pivot point indicators, which identify multiple support and resistance levels as well as the pivot point. Trading often takes place within pivot point levels that mark significant support or resistance levels. Some traders interpret a move through the daily pivot and all of its associated support and resistance levels as a "breakout" that will significantly shift market prices in the direction of the breakout.

Pivot points and their corresponding support and resistance levels are calculated based on the previous trading day's high, low, opening and closing prices. Pivot point levels are widely published each trading day, so it is not necessary for me to reveal the calculation. In addition, you can load pivot point indicators on your chart that automatically calculate pivot levels for you. On a daily basis, the pivot point indicator usually shows three price support levels below the pivot point and three price resistance levels above it.

The Fibonacci retracements support this.

Technical analysis uses Fibonacci retracements as well. Fibonacci was a mathematician whose ratios became popular among traders in the 12th century. Fibonacci levels and ratios can be used to identify trading opportunities and profit targets during sustained trends.

There are four Fibonacci ratios: 0,24, 0,38, 0.62, and 0.76. These are often expressed as percentages - 23.3%, 38.3%, etc. Fibonacci ratios are complementary to one another. The opposite, or remainder, of 76% is 24%, and the opposite, or remainder, of 62% is 38%.

Fibonacci levels can be calculated automatically using several free technical indicators, just like pivot point levels.

The Fibonacci retracement is one of the most common Fibonacci indicators. Following a sustained uptrend or downtrend for some time, a corrective retracement often occurs before price resumes the overall long-term trend. Fibonacci retracements can be used to identify entry points for low-risk trades during such retracements.

Let's take the example of the stock "A" which has steadily risen from $10 to $40. The stock price then begins to fall. During such a price retracement, many investors will seek a good entry point to buy shares.

According to Fibonacci numbers, retracements are likely to extend a distance equal to 24%, 38%, 62%, or 76% of the move from $10 to $40. These levels are watched by investors for signs that the market has found support from where it can begin rising again. You might enter an order at the $31 price level, for example, if you were hoping for a chance to buy the stock after approximately a 38% retracement in price. (The move from $10 to $40 = $30; 38% of $30 is $9; $40 – $9 = $31)

Fibonacci Extensions

In the above example, you have bought the stock at $31, and you are trying to determine a profit target to sell at. Fibonacci extensions indicate how much higher the price could extend when the overall uptrend resumes. Fibonacci extension levels are set at prices that represent 126%, 138%, 162%, and 176% of a previous uptrend, calculated from the low of the retracement. By adding 126% of the original $30 upward movement you find the first Fibonacci extension level and potential "take profit" target at a 38% retracement of the original move from $10 to $40. Calculations are as follows:

Fibonacci extension level of 126% = $31 + ($30 x 1.26) = $68 – giving you a target price of $68.

Of course, you never actually have to calculate these levels. Fibonacci levels can be seen in your charting software by plugging in an indicator.

Even if you don't personally use pivots or Fibonacci levels in your trading strategy, it's worth tracking them. Since so many traders base their buying and selling moves on pivot and Fibonacci levels, if nothing else there is likely to be significant trading activity around those price points, which may help you better determine probable future price movement.

Technical Indicators – Momentum Indicators

Generally, moving averages and other technical indicators are used to determine the likely direction of a market.

However, there is another class of technical indicators whose purpose is less to determine market direction than to determine market strength. Among these indicators are the Stochastic Oscillator, the Relative Strength Index (RSI), the Moving Average Convergence-Divergence (MACD) indicator, and the Average Directional Movement Index (ADX).

Indicators of momentum measure the strength of price movement, which helps investors determine whether current price movement represents relatively insignificant, range-bound trading or an actual, significant trend. Momentum indicators can serve as early warning signs that a trend is ending because they measure trend strength. If a security has been rising steadily for several months, but then one or more momentum indicators indicate that the trend is losing strength, it may be time to take profits.

USD/SGD's 4-hour chart below illustrates the significance of a momentum indicator. Below the main chart window is a separate window displaying the MACD indicator. A sharp upturn in the MACD beginning around June 14th indicates that the corresponding price rise is a trending move, as opposed to a temporary correction. MACD shows weaker price action on the 16th when price begins to retrace downward somewhat, which indicates that the downward movement in price does not have much strength behind it. The uptrend then resumes immediately. During this trading session, the MACD would have helped reassure a buyer of the market that (A) the turn to the upside was a significant price move and (B) the uptrend was likely to resume after the price dipped slightly on the 16th.

Momentum indicators are often combined with other technical analysis indicators as part of a trading strategy, since they typically only indicate strong or weak price movement, not the direction of a trend.

Technical Analysis – Conclusion

No technical indicator is perfect. None of them is 100% accurate all the time.

The smartest traders are always on the lookout for indicators that may be misleading. As a trader, you can certainly improve your profitability with technical analysis. However, what may improve your trading fortunes more is thinking more about what to do if the market turns against you, rather than fantasizing about how to spend your millions.