Technical analysis basics
Technical analysis could be defined in general as a price forecasting method based on the mathematical, but not economical calculations.
Technical analysis – is a price forecasting method of price forecasting with a help of studying diagrams of the latest market movement.
The term market movement analysts understand three major types of information: price, capacity and open interest.
Price - real commodity prices at the markets, as well as currency indexes’ prices etc.
Trading volume – total amount of concluded contracts for a certain period of time, e.g. trading day period.
Open interest – quantity of positions not closed till the end of a trading day.
Not all of these indicators are equivalent. The principal one is the price. It is the most convenient to study and the majority of methods apply to it. Price data is available for every market, and nowadays it is acquired without delay. Finally it is a price that concerns us when performing forward transactions.
Trading volume is the secondary indicator, although it plays rather significant role for price forecasting. Studying its movements is important for understanding the changes of market participants’ preferences, but building diagrams on the periods shorter than one day is not worth the result.
Open interest in an explicit form one may encounter in commodity futures trading. Nearly none of the traders at the FOREX market use it. But we think it should not be completely disregarded. Professional technical analysis is usually done using maximum amount of the available indicators, all three if possible.
Three axioms of technical analysis
It is obvious today that technical analysis is a theory with its philosophy, laws and axioms. Let us study the axioms the technical analysis is based on.
Axiom 1. Market movements include all information.
This statement is a corner-stone of the technical analysis. The main point of this axiom is that any factor that influences the price (economical, political, psychological) is counted beforehand and is reflected in the diagram of this price. That is why studying price diagram is obligatory condition for forecasting.
Axiom 2: Prices move directionally
This axiom is what all the technical analysis method systems are based on. Indeed, if prices moved chaotically, for example, like lottery numbers do, no forecasting would be possible. Fortunately, practice brings conclusive evidence that the axiom 2 is true.
Certain movement direction is called trend. The major purpose of technical analysis is trend determination and forecasting for trading use.
There are three types of trend:
Bullish – Price increase. Bull hocks with its horns and throws upwards.
Bearish- Price decrease. Bear strikes with his paw top-down.
Flat, Sideways – no explicit direction of the price movement. We should note here that prolonged flat is a harbinger of the price storm at the market.
But clear trends of the types named above are quite rare. Price movement is characterized by oscillatory motion, recoils, corrections and turns. That is why the trend when price upward movement prevails (which means every next peak is higher and every next bottom is lower) is usually defined as the bullish one. The same is with the bearish one, save the downward movement prevails. Sideways trend is characterized by the price oscillations which are quite significant at times, but the price movement has no explicit direction.
As practice shows, physical laws of inertia are quite applicable to trends. Here are the most important of them:
In fact, technical analysis was created to determine trends and forecast their conduct.
Axiom 3: History repeats itself
It is natural and obvious. It is so because human psychology does not change through the ages. Technical analysis indirectly studies the history of certain events concerning marketing and it means it studies human psychology. Analysts justly believe that if certain types of analysis worked before, they will be effective in future as well for this job is based on the settled human psychology. Let us remember one of the laws of dialectics – development moves in spiral, constantly repeating itself on higher (or lower) level.
Technical analysis methods’ classification
All diversity of forecasting methods can be described in certain scheme.
1. Diagram methods.
Diagram methods are those that use graphic images of market movements for the forecasting. Those methods appeared before all others for they are very easy to use – all instruments one needs are a pencil and a ruler. Nevertheless those methods are obligatory for the analysis and very effective when combined with other methods.
2. Methods that use filtration of mathematical approximation
Those methods appeared and started to develop quickly with the use of computer. As a rule it implies many cumbersome calculations. Computer connected to the informational network automatically solves all our problems. All we need is to input parameters and analyze a curve we get. Such methods signalize of purchase or sell mechanically. Many traders use them without delving into details of its building.
Technical or fundamental analysis?
Prices can be analyzed and forecast in two methods - fundamental and technical. Actually both methods try to solve the same problem: to define the direction of the future price movements, but approach it from different sides. Fundamentalists study the reasons that influence the market and technical analysts study the very movement. Fundamentalists base on the ordinary logics and constantly ask ‘Why?’ while technical analyst believes that it is not important to know the reason for fundamental analysis is already implied in technical analysis by definition. So who is right?
At the first sight is seems that fundamental analysis is more rational and is to be in advantage. In reality there are markets where it is so. For example, such is the securities market in today’s Russia where the decisions of the Government, the health and behavior of the President are often unpredictable and can literally crash the market. At the other world stock markets the role of the fundamental analysisà is quite considerable as well. But not the FOREX market where same data about economical situation in a country may often lead to the opposite results. This market is like a nervous girl that can faint because of some rumor and ignore the event that has really happened. The crucial moment is that using fundamental analysis one can never take all the factors into consideration, only those who use the most detailed and efficient sources of information have advantage here. And though every trader must know major fundamental factors and take them into consideration in his forecasts, it is not recommended to rely on them completely when concluding some transaction.
Technical analysis is quite ‘precise’, but of course it is not faultless too. That is why fundamental and technical analyses harmonically complete each other.
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