There are two kinds of investors in this world: the “buy and hold” investor, and the day trader. Each group favors a different type of analysis to provide insights for their various investing strategies; the former prefers fundamental analysis, and the latter, technical analysis. While each analytical style is important, all investors can benefit from understanding the basics of technical analysis.
What Is Technical Analysis?
Technical analysis is the study of prior pricing movements for a stock, commodity or currency in order to forecast future pricing behavior with a high degree of success. Commodity producers from centuries ago began to associate pricing patterns with their various planting and harvesting seasons, and traders then began to use charting techniques to their advantage. With the sophisticated software of today, technical charts can assimilate mountains of data and produce instant insights as to where prices might be headed in the immediate and near terms. All investors can profit from this guidance.
Forex trading is one investment discipline where technical and fundamental analyses are used in combination to produce positive results. The chart below is a depiction of the U.S. Dollar Index over the past three months and will provide an example of the basics of technical analysis.
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The beauty of technical analysis is its flexibility. The same principles apply for different investment vehicles, and over various time periods of analysis. The chart above is a “daily” chart. It could just have easily been a minute or hour or even a weekly chart if so desired. Similar pictures would be presented, but the results would vary based on the selected timeframe. The top half of the chart depicts price history, and two popular indicators are shown on the bottom portion.
Identifying The Patterns
The first point to notice is that prices do not move in straight lines, but in zigzag patterns that resemble waves, as if someone jerked the “rope” at one end. The various buy and sell forces in the market are providing the “jerk in the rope”, and the wave pattern represents the cumulative effect of these forces attempting to find equilibrium. A trader is always searching for a trend to guide his entry and exit in the market. Here we see a downward trend until August 9th when a “reversal” occurs, followed by an upward trend.
Notice the nice “sign wave” pattern of the red and clear “candlesticks”. The candlestick symbol presents the high, low, open and close for the trading period, or day in this example. The little box represents the open and close value range, and in this case, it is clear if the closing price was higher than the opening. The opposite is true for Red candlesticks. This charting software has also chosen to show a “Black” bar when a reversal has occurred.
On the key reversal point of August 8th, the bottom “tail” of the candlestick hit the Blue Bollinger band, a “resistance” level, and prices then closed higher. This combination was a signal that prices might move higher during the next trading session. These blue bands are a statistical measure of price level probabilities. When the “tube” structure tightens, it usually expands thereafter, and when various Moving Averages, the red and green lines, cross over a Bollinger border, a potential trend change is indicated.
RSI and MACD Defined
The bottom portion of the chart contains two popular technical indicators know as the Relative Strength Index (RSI), and the Moving Average Convergence-Divergence (MACD). The RSI measures pricing momentum that suggests in advance when a market is “overbought” or “oversold” – points where a trend reversal is imminent. The RSI does not always tell you exactly when the reversal will occur, however. Traders use a lagging indicator, the MACD, to provide confirmation of the RSI signal.
In this case, the RSI was signaling an “oversold” condition, or slow down in price momentum, as August began. The two lines in the MACD crossed on August 10th, a confirmation that a reversal was occurring. A prudent trader would have bought on August 9th, and let his winner run until August 24th when resistance was encountered. He would have profited about 4% over two weeks, much more if leverage or margin had been used.
Technical indicators are not perfect. On many occasions, a false signal can occur. However, a trader is looking for consistency over time. By observing a combination of signals, the trader can draw an informed conclusion about market direction, and then execute a trading strategy to his advantage. Trading is about achieving positive “net” results, and, next to a trend, technical analysis is a trader’s best friend.