What is technical analysis?

Technical analysis (TA) is the study of past prices and trading volumes to identify patterns used to forecast price action. TA can be applied to any asset with a recorded price history, including cryptocurrencies, fiat money, commodities and equities.

Primitive forms of technical analysis appeared in Amsterdam in the 17th century and in Japan in the 18th. The modern discipline arose from the work of the American journalist Charles Dow, founder of The Wall Street Journal. Dow was among the first to observe that assets and markets often evolve in trends that can be segmented and analysed. From these observations he developed what became known as Dow theory.

• Prices reflect everything happening in the market; all present, past and future factors (demand, regulatory changes, participants’ expectations, etc.) are already incorporated into the current price and trading volume. Studying price/volume dynamics suffices to forecast the market’s probable course.
• The priority is “what”, not “why”. A technical analyst focuses on price, not the variables that produce the move. Price reflects opposing forces of supply and demand, closely tied to fear and greed.
• Price movements are not random; they follow trends. The evolving balance of supply and demand over time forms short-, medium- and long-term trends. When demand exceeds supply an uptrend forms; when supply exceeds demand, a downtrend. When demand and supply balance, a sideways trend (range) emerges.
• History tends to repeat itself. Market psychology can be anticipated because traders react in stereotypical ways to similar factors.

Unlike TA, which gives primacy to price history and trading volumes, fundamental analysis (FA) seeks to assess an asset’s intrinsic value and weighs both quantitative and qualitative factors, including:

• financial and operating metrics;
• management and corporate reputation;
• market competition;
• the overall state of the industry, and so on.

These data are used to project the asset’s future performance.

FA is more effective and reliable in markets operating under normal conditions, with large trading volumes and high liquidity. Such markets are less prone to price manipulation and external influences that generate false signals and make TA of limited use.

TA is used mainly to forecast price moves and market behaviour, while FA is a method for valuing an asset according to its potential and context.

TA is popular with short-term traders; FA with fund managers and long-term investors.

TA examines patterns—typical shapes on price charts (“Double bottom”, “Triangle”, “Flag”, etc.)—and levels often based on prior highs or lows. As price approaches earlier peaks, participants expect similar reversals and place orders accordingly, which in turn creates resistance and support levels.

Charts are used to analyse prices, levels and patterns over set time periods. The most popular among traders are Japanese candlesticks, line charts and bar charts.

Japanese candlesticks can be used as standalone TA models or combined with additional tools—geometric shapes, indicators, oscillators, and so on.

Patterns are usually identified on charts by traders themselves, without auxiliary mathematical tools.

• Horizontal line — a straight line marking price levels on the chart.
• Trendline — a sloped line used to identify a trend.
• Derived lines based on mathematical processing of user-specified key values (Fibonacci levels, Gann lines).

Technical indicators are additional charts derived from recalculating values contained in the underlying price chart. They have at least one adjustable parameter; changing it can materially alter the results displayed. TA employs indicators and metrics such as:

Simple moving average (SMA), calculated from closing prices over a set period.

Exponential moving average (EMA), a modified version of SMA that places greater weight on recent closes.

Relative Strength Index (RSI), a type of indicator known as an oscillator. Unlike simple moving averages, which merely track prices over time, oscillators apply mathematical formulae to price data to produce readings within preset ranges. For RSI the range is 0 to 100.

Bollinger Bands (BB), an indicator consisting of two bands enveloping a moving average. It is used to identify potential overbought and oversold conditions and to gauge market volatility.

Alongside basic tools, TA also uses instruments built on other indicators:

Stochastic RSI, calculated by applying a mathematical formula to the standard RSI.

Moving Average Convergence Divergence (MACD), generated by subtracting two EMAs to create the main (MACD) line. An EMA of that line produces a second, signal, line. There is also a MACD histogram (a graphical representation of statistics) based on the differences between the two lines.

Indicators not only help identify broader trends; they also suggest potential entry and exit points (buy and sell signals). Signals are generated when certain events occur on an indicator’s chart. For example, an RSI reading of 70 or higher may indicate overbought conditions, while a fall to 30 or lower usually signals an oversold market.

TA’s trading signals are not always accurate. Indicators produce considerable “noise” (false signals), especially in cryptocurrency markets, which are far smaller and more volatile than traditional financial markets.

Critics call TA a “self-fulfilling prophecy”: events occur only because many people deem a given scenario likely. As numerous traders and investors use the same indicators, such as support and resistance, these patterns become operative. On the other hand, each trader analyses charts in his or her own way, using a multitude of available indicators, so a large group of technicians cannot follow the same strategy.

Although TA deals with empirical data, it is not free from bias and subjectivity. A trader predisposed to certain conclusions about an asset can manipulate tools to buttress his or her view, often unconsciously. TA also falters when the market offers no clear patterns or trends.

Many consider the most rational approach to combine FA and TA: the former works well for long-term investment strategies, the latter for short-term trades.

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