Fundamentals of Technical Analysis

Posted by reallynicearticle on January 16th, 2021

Technical analysis was truly an arcane art before the internet boom. Chartists perform technical analysis in their secret rooms with data that was carefully collected from professional sources. Those were the times when stock prices and data did not have a medium through which to be readily available to the public and be ran through publicly available software to produce the charts that are available today.

Today, with internet in almost every household, teknisk analys  technical analysis became an art anyone could practice. Complex charts, technical indicators and analysis that was once the sole domain of a few highly paid wallstreet analysts are now available to anyone who wants it, often for free.

Technical analysis also became linked to short term aggressive trading instruments such as stock options and futures because of its excellent short term predictive nature.

With technical analysis this popular, I feel obligated to teach you once and for all everything you need to know about how to conduct proper technical analysis before you start looking at your first chart. A lot of amateurs fail at technical analysis simply because they didn't have the necessary basic knowledge to understand how to interpret technical indications properly in the first place. With the knowledge in this article, you will definite experience more success at technical analysis.

Summary of Technical Analysis Basics

2 Principles of Technical Analysis: Significance, Prudence

2 Key Tools: Charts, Indicators

2 Key Components: Price, Volume

5 Key Concepts: Resistance, Support, Trend, Patterns, Setups

2 Principles of Technical Analysis: Significance, Prudence

The two principles of technical analysis are the most important foundation in understanding technical analysis and interpreting technical analysis properly. Too many amateurs misinterpret technical indications simply because they did not understand these two simple principles. This is also the only part in this tutorial that addresses the mental aspect of technical analysis and should be clearly understood before moving on. The two principles of technical analysis are Significance and Prudence.

Principle #1: Significance

Significance refers to the degree that a technical indication is true. Take breakout and reversal signals for example. Does a 0. 5% close above a resistance level indicate a breakout? Does a 1% reversal in a bearish stock that has fallen more than 40% indicate a reversal? No. The degree of significance for both cases is just too weak. Most technical analysis beginners who do not understand the principle of significance would take a small fake out as a breakout and then act on the wrong stocks. The judgment of significance is, however, a matter of experience. How much of a breakout represents a significant breakout? How much of a reversal represents a significant reversal and how big a candle represents a strong morning star signal? The judgment of significance is something you need to acquire and refine as you put more years behind your ears.

Principle #2: Prudence

Prudence refers to the ability to say "No" when in doubt. Technical analysis is more of an art than a science. This is because even though technical indications are scientifically generated, the interpretation of technical indications is highly subjective. You are going to experience many marginal or doubtful moments in technical analysis. Technical signals that "almost made it" as well as technical signals that are "neither here nor there". Those are the times to exercise the technical analysis principle of Prudence and to make the most conservative interpretation. When a signal is marginal, you should always exercise prudence by giving benefit of the doubt to disqualifying the signal. When a significant breakout signal is produced after a huge drawdown, you should exercise prudence by waiting for further confirmation or enter the position gradually over a few days.

2 Key Tools: Charts, Indicators

Key Tool #1: Charts

Chart reading is the most fundamental tool in technical analysis and is also why technical analysis is frequently referred to as "Chartology". Before the popularization of the internet, during the age where analysts still read tapes, technical analysts have to obtain stock quotes from "secret sources" and then plot them down on huge chart papers in their secret rooms. What then is a chart? A chart is simply a plot of the stock prices made into a curve. A chart's basic function is to show the TREND of a stock's price action. Without a chart, a stock closing at a price of has no meaning at all. With a chart, you can clearly see the price action trend down from 0 to , giving investors the first indication of where the future price action of that stock might be. In the beginning, charts are plotted merely as a single line joining the prices together. Recently, with more and more powerful computers and software, more innovative and informative plotting methods like candlesticks, bar charts and point and figure charts are developed and made easily available through the internet. No matter what type of chart you look at, the only aim is to provide an indication of where the future movement of the stock might be. Another important aspect of charts is "Chart Patterns". Different types of charting method can produce easily recognizable patterns and formations that can be associated with certain future expectations. Popular chart patterns include "morning stars" in candlestick charting, "double top breakout" in point and figure charting and "double bottom" formation.

Key Tool #2: Indicators

Technical Indicators are the other key tool in technical analysis. Technical indicators are graphical representations of various mathematical formulas based on the stock price and transaction volume. The are literally thousands of technical indicators out there and more are being developed daily as new finance theories are translated into mathematical formulas every day. Technical indicators' main function is to tell when a stock is considered oversold or overbought and when a stock is considered weak or strong relative to its past action. There are literally endless amount of formulas that can be used to provide those indications, hence the endless number of technical indicators. Because there are so many different technical indicators out there, beginners should start with a few well known and widely used ones as those tends to be used by institutional investors as well. It can be argued that the effectiveness of a technical indicator lies in its popularity. The more investors acting on the same indicator, the stronger the predictive nature of the indicator becomes. A self fulfilling prophecy? Maybe.

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Why You Should Understand Technical Analysis When Analysing Financial Instruments

Technical analysis has been around for many hundreds of years, dating back to the 18th century when a Japanese rice trader developed candlestick charting.

Just after the turn of the 20th Century, Charles H. Dow's (as in Dow Jones) contributions greatly increased the discipline's prominence and his works were then expanded upon most notably by Hamilton (1922) and Rhea (1932), and a host of others thereafter.

Despite the continued development of the theoretical side of the discipline, until quite recently technical analysis remained confined to the realm of large institutions that possessed the necessary money and resources required to utilise it effectively.

Initially the money and resources were used employing research analysts who would construct and maintain hand-drawn charts but this eventually gave way to computers. In the early days, however, computers filled entire rooms and, once again, could only be afforded by large institutions.

It has only been in the last 10-15 years that personal computing power has allowed retail traders/investors the opportunity to utilise technical analysis as a tool for analysing financial instruments which, in all honesty, has proven to be both a good thing and a bad thing.

For an example of how far along we've come in this area, one need look no further than the I-phone which already allows traders/investors to access trading platforms and charts in order to place trades at any time, wherever they may be around the world.

Interestingly, technical analysis has also become a significant source of revenue and profit for major financial institutions due to technological advancements, i. e. the Goldman Sachs of this world.

Algorithmic and high frequency trading have developed because computers can read information, interpret it, and execute orders much, much faster than human beings. The clear majority of these systems are based on price action and technical rules, not fundamental ones.

Whilst the discussion of these types trading goes beyond the scope and purpose of this article, it is interesting to note that the traditional broker/dealer model, whereby research analysts provide fundamental analysis based recommendations for brokers to sell and, in turn, dealers to execute, is being chipped away at by technical analysis driven, computer executed, algorithmic trading methodologies.

The growth of technology and the subsequent ease with which retail traders/investors can access the market has also given birth to a new class of people who have adopted the misguided belief that they can achieve success in the market through the use of technical analysis, despite the fact that they have very little education or experience.

And this is not entirely the fault of the individual. A large portion of the blame must be worn by the many and varied 'operators' out there who have hijacked technical analysis and promoted it as a means by which people can make quick and easy riches.

The quick and easy part could not be further from the truth and it is the promotion of the discipline in this way that, in my opinion, causes significant damage to new traders/investors and, as an extension of that, the discipline itself.

Technical analysis, like any other method of financial analysis, is not something which can be learnt overnight and it should never be promoted as such. It requires a considerable amount of focused learning before one might be considered competent in the area.

Once a competent level is reached, it then takes many more years of study and application before one may be considered an expert in the field. To put it in perspective, I have been studying technical analysis for five years (including both private and accredited learning) and I would consider myself just above competent. That being said, technical analysis does not necessarily require as much learning as some other areas of financial analysis which, once again, creates a double-edged sword.

To flesh out this assertion, consider the following comparison between technical analysis and fundamental analysis.

Fundamental analysis is a traditional discipline which is taught at the most prestigious business schools around the world. It involves looking at a company's revenues, expenses, assets, liabilities and all the other financial aspects of a company in order to determine its value.

The process can and should involve in-depth analysis of the company's balance sheet and income statement, which often requires application of some very complex mathematical formulas and quantitative models.