Traders use technical analysis to help them better understand what is happening in the marketplace and gain potential insight into what may happen next. Many traders who are new to technical analysis often have misconceptions about what it is and isn’t and what it can do for them. There are five important aspects to technical analysis that can, if better understood, help traders better determine entry and exit points as well as offer clues to potential future price direction.
1. All Information about the markets is found in its price action
Fundamental analysts focus on things like earnings and sales figures to determine the proper “value” for a given stock. A technical analyst is less interested in “why” a stock or asset trades at a given price, and more interested in where it may be headed next. In essence, a technical analyst believes that all good and bad “news” regarding the market or asset are already reflected in the price information.
They are focused instead on the momentum that may be driving the current trend, and are trying to measure where and when present conditions may change.
2. Trading volume can offer important information
Many price movements - such as a breakout to a new high, for example - are generally considered to be of greater significance if accompanied by above average trading volume. To most technical analysts, the greater the trading volume, the more “valid” the breakout is typically considered to be, because large volume signifies great conviction and enthusiasm on the part of traders. This is why volume appears on almost every technical trader’s chart before any other indicator or tool.
3. Markets are driven by psychological factors in addition to fundamental values
Demand for a given security increases or decreases based on the collective assessment that all traders make regarding the real or perceived value of that security. For example, an announcement regarding strong sales and earnings growth for a given company may cause traders to have a more favorable opinion regarding the stock of that company. As a result, demand for the company’s shares may increase. A technical analyst will attempt to identify this by recognizing improving price action and increased trading volume.
4. Prices tend to move in trends and patterns
Public perceptions can change quickly. Sometimes these changes affect perceptions regarding the overall stock market or broader financial markets in general. Other times these changes affect only a particular segment of the market or a particular stock. Much of the time, however, the price of many assets move actively without any attendant “news” that might explain “why” this movement is taking place. This often makes it appear that price movements are random. However, experience has shown that price action often falls into patterns and/or “trends.”
A “trend” can be defined as the general direction of given a security’s price over a given period of time. A trend is assumed to be in effect until a clear signal is given that that particular trend has reversed.
Types of trends
There are three different types of trends: up, down, or sideways.
An Uptrend is defined as a series of higher lows and higher highs over a given period of time. Connecting these increasing low points with a trend line is a standard technical analysis tool that can help to identify whether or not an uptrend is still intact.
A Downtrend is defined as a series of lower highs and lower lows. Connecting these decreasing high points with a trend line is a standard technical analysis tool that can help to identify whether or not a downtrend is still intact.
A Sideways trend is a series of highs and lows within a relatively flat or compressed range. Connecting these high and low points with a couple of trend lines can help to identify the trading range. A standard tool of many technical analysts is to look for breakouts above or below a defined trading range to signal when a new uptrend or downtrend may be starting.
Trend timeframe can play a very important role for many traders. Price trends can last for days, weeks, months, years or for as little as just a few minutes. It is important to consider what length of timeframe is most important to your own style of trading. The longer a given trend persists the greater its significance. It is typically believed that the longer the time frame, the stronger and more useful the signals that it gives. For an intraday analysis, the trend using 1-minute bar charts may be important. For virtually all analysis timeframes, minute-by-minute price gyrations are simply not meaningful. Trend duration breaks down into three timeframes:
This category includes trends that last anywhere from six months to several years. In the example below we see the price chart for a security that experienced a sustained downtrend for six full months before reversing to higher ground.
Secondary, or intermediate trend
This category typically includes trends that last anywhere from one to six months. In the example below we see the price chart for a security that experienced a sustained uptrend for most of the three months shown. Note in this chart however, that even a persistent uptrend does not move in a straight line, and that minor pullbacks along the way are common and to be expected.
Minor or short-term trend
This category of trend usually lasts from a day up to a couple of weeks.
Remember: “The Trend is Your Friend”
Because the concepts of trends are so central to technical analysis, many traders have a saying about them, “the trend is your friend.” This adage suggests that traders take advantage of the prevailing primary trend, rather than trading against - or “fighting” - it.
In fact, most of the tools, studies, and patterns found in technical analysis attempt to identify trends in a variety of ways. For example, some tools simply attempt to identify a current trend as up, down or sideways. This simple designation can provide important and useful information. Other tools however, attempt to determine how strong a given trend is in terms of persistence how fast it is moving, and whether it is going to continue or reverse direction.
5. Work to build your weight of evidence - not to find the Holy Grail
Trading signals can provide traders a clear set of criteria to look for and help them better identify potential trading opportunities.
However, using just one technical analysis tool or indicator only gives you a fraction of the picture of what is happening with the market or asset. On the flip side, using too many indicators can potentially result in a trader becoming overwhelmed or having “analysis paralysis” by the number, and at times conflicting, trade signals.
Many traders look for trade signals from a combination of just a few tools and indicators to build their “weight of evidence” to help them make more objective and less emotional trading decisions instead of reacting to any price movement on a reactionary basis.
No technical tool or indicator will have a perfect trading signal track record. There will always be the potential for false or conflicting signals. There’s also no specific number or combination of tools or indicators that will work for everyone. That’s why it’s important to identify a few clear trading signals that you understand, and that best fit your trading strategy.
It’s a good idea to more closely examine the technical analysis tools that are of interest to you. Doing this can help you gain a better understanding of how each tool works so that you can determine how they best fit with your trading strategy and trade plan.