Technical Analysis is one of the two basic approaches to understanding and trading the financial markets; the other approach or discipline being fundamenal analysis. Although both of the two approaches are used to achieve the same goal, which is to understanding price action, the debate as to which is a better approach forms an endless point of conversation.
Technical analysis can be defined as follows:
Technical analysis is the study of price action based on the principle that all the information that is available in the markets is already discounted and shown by price. Therefore technical analysis is nothing but the studying past price action to predict future price.
Technical analysts, are also known as chartists and employ various tools, most of which are mathematical or linear in nature. For example, the commonly used moving average is nothing but an average price calculated over a period of time. Therefore, when price trades above the moving average, it simply infers that the current price is bullish. Likewise, when price trades below the moving average, it is considered to be bearish.
Technical analysis also makes use of commonly occuring patterns. The head and shoulders is one such example which depicts how a visually occuring pattern often predicts an impending bearish or bullish price action.
Technical Analysis Tenets
Technical analysis works on some basic tenets, listed below:
- That all the fundamentals of the market are echoed in the price data. The underlying reasons for the price movements are not essential in technical analysis.
- The Forex market moves in repetitive patterns. These patterns are known as trends and are used as signals to govern a technical analyst investment strategy. The objective of technical analysis is to actually predict future trend by analyzing past trends.
- Because prices in the Forex market moves in predictable ways, Technical analysts do not believe that price fluctuations are random. Thus, once a trend has been established, it will continue for a certain period.
Proponents of Fundamental Analysis however discount technical analysis on the basis that it is the fundamental factors that drive price action and therefore find no basis for predicting future price. This is true to an extent. For example, technical analysis cannot predict a central bank rising or slashing interest rates. But it surely can give an idea about the event based on the technical indicators being used. Another example can be seen in the stock markets where fundamental analysis such as price/earnings ratio, etc take more importance than technical analysis. On the contrary, most forex traders tend to put more focus on technical analysis. Regardless of the debate, the best approach is to make use of a combination of both technical and fundamental analysis. Read more about the various tools available in technical analysis.
A good approach is when a trader pays attention to the underlying fundamentals and then takes a trading decision based on technical analysis. For example, we might learn that a quarterly GDP report came out below expectations and lower in comparison to another currency. While this scenario might alert us to sell the currency with a weaker GDP report, fundamental analysis does not point to an ideal price level to short from. This is where technical analysis comes into the picture by showing the trader past key price points thus allowing the trader the most ideal price to short from as well as point to a price level to set the stop loss.