Trading 101: Technical Analysis
Hearing about technical analysis may trigger various images in your mind. Perhaps it creates the image of the analyst behind his desk with a dozen computer screens in front of him, showing sophisticated multi-colored charts. Maybe you think about the algorithmic trader, who codes his bots that automatically execute his strategy. Or the lifestyle trader, the digital nomad, having his trading laptop on the poolside, driving his Lamborghini around a holiday resort, enjoying the good life. There is a bit of truth in all of them, but the images being sold are, in most cases, just marketing.
A second or third screen won’t make you a better trader. The Bot won’t bring in any consistent profits if you don’t understand the concepts of the market. Just as the distractions of a luxury lifestyle surely won’t make it any easier to stay focused. What you need is discipline, an understanding of the markets and economy, and a systematic approach. It doesn’t matter with how many screens you do this with, if you trade manually, or choose an algorithmic approach, or what you do with your new-found financial independence. All of this is worth nothing if you don’t pay your dues to understand and excel at what you need to do to increase your odds of a winning trade – technical analysis.
If you are new to technical analysis, this article will give you an introduction to the discipline of it, and our work as traders. If you are already an experienced trader, you may still nonetheless find some interesting insights, perceptions, and misconceptions about technical analysis while reading our article series.
The five pillars of Technical Analysis
A novice to the world of trading, you may wonder what exactly technical analysis is all about. At a basic level, technical analysis is the examination of price movement in tradeable markets, with the intent to make profitable trading decisions. Taking it a step further, we can see that technical analysis relies on five core assumptions.
Price is determined by the interaction of supply and demand.
Prices move in trends.
Changes supply and demand cause reversals in trends.
Changes in supply and demand can be detected on the chart.
Chart patterns are likely to repeat themselves.
The most important thing for the technical analyst is the chart, as the technical analyst studies the action on the markets instead of the markets themselves. Fundamentals play a low-level role to the technical analyst. There is a simple core belief in technical analysis: the market is always right. The fundamental analyst will try to take all factors about a cryptocurrency, company or any other asset into consideration and create a prediction for the direction of price in the future. However, it’s impossible to find a conclusive result due to an almost endless number of interacting factors. Even more so, as market participants tend to overlook important information in favor of the current hot new trend on the block.
A short excursion to Fundamental Analysis
The contrary has been proven true. The market is the best predictor of the fundamental trend of an asset or whole economies. A new bull trend will form while the economy is still deep in recession (B on the Graph), just as a new bear trend will start to form while the economy is at peak growth (A on the Graph). In both cases, no fundamental factors will signal the analyst to buy or sell yet. The delay of the fundamental trend aligning with the financial markets, like stocks and commodities, can amount up to several months. In conclusion, the “fundamental analyst” is always behind in the financial markets, and is unable to beat it with any great margin. Of course, the fortunate exceptions exist, making massive value investments, which seem to be rather lucky punches than a systematic approach.
Perhaps even more so than by information and misinformation, markets are influenced by emotions and psychological factors. Fear, greed, unfounded expectations, cognitive biases, and many other psychological effects affect the prices heavily, making an accurate prediction of price movements via fundamental analysis nearly impossible. Rather than trying to do the impossible, the technical analyst believes that all available information is already factored into the price of an asset at any given time. Whatever you think may happen, it’s already priced in.
Back to Technical Analysis
The purpose of technical analysis is to find changes in supply and demand. In turn, the analyst identifies the changing trend early on, which lets him to position himself ahead of the other market participants to maximize his profit. To achieve this, the technical analyst uses a wide array of indicators. Some of these indicators are reactive, like moving averages, while others have a predictive character, e.g. Fibonacci retracement. Technical analysts are reactive and treat specific events on the chart as a signal to enter or leave a trade. Statistically, reactive trading approaches have a higher strike rate than predictive approaches. However, that does not mean that reactive approaches are better in general, and predictive approaches are to be disregarded. Every approach used correctly will have its advantages and chance to gain you an edge over the market.
The indicators and the trading systems used by a technical analyst are not magic crystal-balls that predict the future. They are tools to increase your odds of finding a profitable trade. Under certain market conditions, they may work great, while under changing conditions they might not work at all. To convert technical analysis into money, several, although simple, requirements are mandatory. Being early in the demand (trend turning up), setting a stop-loss (control of losses), in case the trend turns against you, being early in the supply (trend reversing downwards), and controlling your emotions (avoid overtrading and ruin).
Play the trend – Control your losses – Avoid Ruin
While we already talked about the core assumption of technical analysts – that price and trends are formed by supply and demand in conjunction with human psychology (nobody buys an asset without the expectation of profit). There are a few other assumptions technical analysts make.
The price discounts everything.
All available information and expectations of the masses are already included in the current price.
History repeats itself in a similar manner.
Human behavior does not change; similar behavior will form into recognizable patterns in the chart, with predictable results.
Patterns are fractals.
Patterns occur over all time-frames at the same time. A pattern on a lower time-frame will always be a part of a pattern on a larger time-frame. At the same time they work the same over all periods of time.
Market memory exists.
Some price points of the past can be used to predict future trends. They become important psychological levels, and the price going above them or getting rejected below them decide the further trend.
Emotion-feedback echoes price.
A trader buys an asset, expecting a rally, convinces all his friends to do the same.His friends convince their friends. The domino effect continues, as they are propping the price higher and higher. This unfolds in what we call a ‘bubble’, as the emotion feedback expands beyond equilibrium.
Technical Analysis is a complex, ever-evolving, and ever-expanding discipline. Back in the day, most traders would learn how to trade from a mentor with whom they worked. Nowadays, traders just hit up their preferred search engine and try to find information on their own. Considering the massive overflow on information, an absolute chaos of tools, ideas, folklore and even esotericism (yes, some people take their trades depending on moon phases), we thought that a coherent and straightforward guide into the topic of technical analysis and trading would be something valuable we have to offer. Even more so, if you’re just a beginner, joining a highly motivated traders’ community is the one thing that will help you kick-start your skill set in the quickest way possible. You become who you surround yourself with.