What is technical analysis?

Introduction

Technical analysis (TA) is a method of analysis that utilizes past price movements and trading volumes to forecast the future behavior of the market. It is applied to both traditional financial assets and digital currencies.

In contrast to fundamental analysis, which takes into account various factors influencing asset prices, technical analysis solely focuses on historical price data. It enables the analysis of price fluctuations and trading volumes to identify trends and opportunities for successful trading.

Technical analysis has deep historical roots, with predecessors such as Charles Dow, the founder of The Wall Street Journal, who first noticed that markets and assets often follow specific patterns. Building upon this work, the Dow Theory contributed to the development of modern technical analysis. In its early stages, it was limited to manual tables and calculations, but with technological advancements, it became a widely used tool for investors and traders.

How Technical Analysis Works

Technical analysis relies on the examination of both current and past asset prices, operating under the belief that price fluctuations adhere to specific patterns, rather than occurring arbitrarily. This analytical method delves into the interplay between market supply and demand, mirroring the overall sentiment of traders and investors, which is often driven by emotions such as fear and greed.

Technical analysis is most effective when applied to markets characterized by high liquidity and substantial trading volumes that function within typical parameters. In such environments, prices are less vulnerable to manipulation or external factors that could distort the findings of the analysis.

To evaluate prices and discern promising opportunities, traders employ charting tools commonly referred to as technical indicators. These indicators aid in the identification of both existing and potential market trends. Since the results of technical analysis are not consistently foolproof, some traders choose to utilize multiple indicators concurrently to mitigate risks.

Indicators of Technical Analysis

Instruments of technical analysis play a vital role for traders, empowering them to assess the market using charts and past price actions. Among the commonly utilized indicators, one finds the Simple Moving Average (SMA), which takes into account an asset's closing prices over a specified timeframe. The Exponential Moving Averages (EMA), a variation of SMAs, gives more weight to recent closing prices.

The Relative Strength Index (RSI) stands as another prevalent indicator categorized as an oscillator. Oscillators, differing from moving averages, apply mathematical formulas to analyze price data within a set period. RSI, for example, operates within a range of 0 to 100, providing insight into market conditions being either overbought or oversold.

Bollinger Bands (BB) represent another oscillator, comprising upper and lower boundaries encircling the moving average. They help identify situations of market overbuying or overselling and gauge volatility.

Beyond basic tools, there are indicators built upon other indicators. For instance, the Stochastic RSI employs the RSI and mathematical computations. Another illustration is the Moving Average Convergence Divergence (MACD), computed using exponential moving averages and generating signals based on divergences between these lines.

Trading Signals

Technical indicators play a crucial role in identifying entry and exit points when trading. For instance, when the RSI exceeds the level of 70, it may indicate overbought conditions in the market, while a drop in RSI below 30 typically suggests oversold conditions.

However, it's essential to remember that trading signals obtained through technical analysis are not always entirely accurate and can sometimes be false, especially in more volatile cryptocurrency markets. Traders should exercise caution and utilize additional tools and analysis to make well-informed decisions.

Criticism

Technical analysis has its critics who label it as unreliable and a "self-fulfilling prophecy." This means that some events might occur simply because a large number of people believe in specific indicators and follow them.

Debates about the reliability of technical analysis revolve around the question of whether many traders, relying on the same indicators, can influence the market. At the same time, proponents of technical analysis argue that every trader develops their unique strategies, and, therefore, there is no single strategy that everyone would use.

Fundamental Analysis vs. Technical Analysis

Fundamental analysis and technical analysis represent two contrasting approaches to evaluating contemporary financial markets and assets. Technical analysis operates on the assumption that current market prices already factor in all the pertinent fundamental factors associated with a particular asset. In contrast to technical analysis, which relies on historical data and trading volumes, fundamental analysis employs a comprehensive research methodology with a focus on qualitative aspects.

Proponents of fundamental analysis argue that future price fluctuations in an asset are determined by more than just historical data. They contend that fundamental analysis provides analysts with the tools to assess the intrinsic value of an asset, considering a wide range of factors like management quality, reputation, competitive landscape, growth rates, and the overall market environment. On the other hand, technical analysis is predominantly favored by short-term traders who use it to predict price movements. However, it's important to acknowledge that technical analysis can be susceptible to subjective interpretation and personal biases. For example, traders may unconsciously or deliberately interpret analysis results to align with their own expectations. Furthermore, it is believed that technical analysis may be less effective during periods when the market lacks distinct trends.

Both fundamental and technical analyses continue to be relevant in today's dynamic financial landscape, with investors and traders often employing a combination of these methods to make informed decisions. The choice between these two approaches depends on the individual's investment horizon, risk tolerance, and overall market conditions. While some investors find value in fundamental analysis's deep insights into an asset's intrinsic worth, others may turn to technical analysis for short-term trading strategies. In the end, the effectiveness of each method may vary depending on the specific asset, the market environment, and the investor's skill and experience.

Summary

Depending on long-term or short-term investment strategies and taking into account arguments from both proponents and critics of both methods, it is recommended to use a combination of fundamental and technical analyses. Fundamental analysis positively influences long-term investment decisions, allowing for an assessment of an asset's intrinsic value. Meanwhile, technical analysis provides real-time information on short-term market conditions, which is beneficial for both traders and investors, for example, when making decisions about market entry and exit timing. This combination of methods can be the most effective in achieving investment goals.