Technical analysis (TA), often referred to as chart analysis, is a type of analysis aimed at predicting market behavior in the future based on previous price and volume data. The TA approach is widely applied to stocks and other assets in traditional financial markets and is also an integral part of trading digital currencies in the cryptocurrency market.
In contrast to fundamental analysis (FA), which considers a multitude of factors surrounding asset prices, TA strictly focuses on historical price fluctuations. Therefore, it is used as a tool to study price movements of assets and volume data, and many traders apply it in an attempt to identify trends and profitable trading opportunities.
While primitive forms of technical analysis emerged in Amsterdam in the 17th century and in Japan in the 18th century, modern TA is often attributed to the work of Charles Dow. A financial journalist and founder of the Wall Street Journal, Dow was one of the first to notice that individual assets and markets often move in trends that can be segmented and studied. His work later gave rise to Dow Theory, which contributed to the further development of technical analysis.
In its early stages, the primitive approach to technical analysis was based on handwritten tables and manual calculations, but with the advancement of technology and modern computing systems, TA has become widespread and is now an important tool for many investors and traders.
How Technical Analysis Works
As mentioned earlier, technical analysis primarily involves studying current and past asset prices. The fundamental assumption underlying technical analysis is that price fluctuations of an asset are not random and typically develop into specific trends over time.
At its core, technical analysis is an analysis of market forces of supply and demand, which are a reflection of the overall market sentiment. In other words, the price of an asset reflects the interplay of buying and selling forces, and these forces are closely tied to the emotions of traders and investors (mainly fear and greed).
It is worth noting that technical analysis is considered more reliable and effective in markets that operate under normal conditions, with high volume and liquidity. Markets with high trading volume are less prone to price manipulation and anomalous external influences, which can create false signals and render technical analysis useless.
To study prices and identify profitable opportunities, traders use various charting tools known as indicators. Technical indicators can help traders identify existing trends and also provide valuable information about trends that may emerge in the future. Since technical indicators are not infallible, some traders use multiple indicators as a way to mitigate risks.
Common Technical Analysis Indicators
Traders utilizing technical analysis (TA) typically employ various indicators and metrics to identify market trends based on charts and historical price actions. Among the many indicators of technical analysis, simple moving averages (SMA) are one of the most well-known and widely used examples. As the name suggests, SMA is calculated based on the asset's closing prices over a specified period. The exponential moving average (EMA) is a modified version of SMA that gives more weight to recent closing prices compared to older ones.
Another widely used indicator is the Relative Strength Index (RSI), which is part of the oscillator class of indicators. Unlike simple moving averages that simply track price changes over time, oscillators apply mathematical formulas to price data and then produce readings that fall within pre-defined ranges. In the case of RSI, this range is from 0 to 100.
The Bollinger Bands (BB) indicator is another type of oscillator that is quite popular among traders. The BB indicator consists of two side bands that move around the moving average line. It is used to identify potential overbought and oversold conditions in the market, as well as to measure market volatility.
In addition to more basic and simple TA tools, there are indicators that rely on other indicators to derive data. For example, the Stochastic RSI is calculated by applying a mathematical formula to the regular RSI. Another popular example is the Moving Average Convergence Divergence (MACD) indicator. MACD is generated by subtracting two exponential moving averages (EMA) to create the MACD line. Then, the first line is used to create another EMA, resulting in the appearance of a second line (known as the signal line). Additionally, there is the MACD histogram, which is calculated based on the difference between these two lines.
Trading Signals
While indicators are useful for identifying overall trends, they can also be used to provide information about potential entry and exit points (trading signals). These signals can be generated when certain events occur on the indicator chart. For example, when the RSI issues a value of 70 or above, it may indicate that the market is operating in overbought conditions. The same logic applies when the RSI falls to 30 or below, which is usually perceived as a signal of oversold market conditions.
As discussed earlier, technical analysis trading signals are not always accurate and in some cases can turn out to be false. This is particularly important for cryptocurrency markets, which are much smaller than traditional markets and therefore more volatile.
Criticism
Although TA is widely used in all markets, many experts consider it a controversial and unreliable method, often referred to as a "self-fulfilling prophecy." This term describes events that occur only because a large number of people expect them to happen.
Critics argue that in the context of financial markets, if a large number of traders and investors rely on the same types of indicators, such as support or resistance lines, the chances of them working increase.
On the other hand, many supporters of TA argue that each analyst has their own way of chart analysis and utilizing a variety of available indicators. This means that it is almost impossible for a large number of traders to use the same strategy.
Fundamental Analysis vs. Technical Analysis
The main concept of technical analysis is that market prices already reflect all the fundamental factors related to a particular asset. Unlike the TA approach, which mainly focuses on historical price and volume data (market charts), fundamental analysis (FA) applies a broader research strategy, paying more attention to qualitative factors.
Fundamental analysis considers that the future performance of an asset depends on much more than just historical data. Essentially, FA is a method of assessing the intrinsic value of a company, business, or asset based on a wide range of micro- and macroeconomic conditions, such as management and company reputation, market competition, growth rates, and industry conditions.
Therefore, it can be said that unlike TA, which is mainly used as a tool to forecast price actions and market behavior, FA is a method of determining whether an asset is overvalued or undervalued, considering its context and potential. While technical analysis is primarily used by short-term traders, fundamental analysis is usually preferred by fund managers and long-term investors.
One advantage of technical analysis is that it is based on quantitative data. Thus, it provides a framework for objectively studying price history, eliminating some uncertainty associated with the more qualitative approach of fundamental analysis.
However, despite dealing with empirical data, TA is still subject to personal biases and subjectivity. For example, a trader who strongly leans towards a certain conclusion about the value of an asset is likely to be able to manipulate their TA tools to support their biases and reflect their preconceived notions, and in many cases, this happens unconsciously. Additionally, technical analysis may also fail in periods when no clear patterns or trends are observed in the markets.
Summary
Despite criticism and prolonged discussion about which method is better, many consider a combination of FA and TA approaches to be a more sensible choice. While FA is typically associated with long-term investment strategies, TA can provide useful insights into short-term market conditions, which can be beneficial for both traders and investors (e.g., when attempting to identify favorable entry and exit points).
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