When it comes to understanding and evaluating the markets, technical analysis and fundamental analysis is what you need to rely on.
While fundamental analysis is an approach towards making trading decisions by looking at the overall economic trends, industry conditions, and financial strength, technical analysis, on the other hand, aims to understand the market sentiment by studying past market data like price and volume and look for patterns and trends to predict the direction of price movements.
Why is Technical Analysis Important for Trading?
The technical analysis benefits in several ways:
Know when to enter and exit: The importance of technical analysis lies in the fact that it readies a trader to identify the right time to make investments and exit with profits.
Studying the past patterns and implying them for the future: The historical data and charts can be used to understand market reactions and imply them for a longer term.
Capture the momentum of trends: Technical analysis easily helps one to spot trends – be it an upward trend, downward trend or sideways trend.
Support and resistance: Support and resistance are one of the most widely followed technical analysis techniques to identify price points on a chart that tends to stop and move in the reverse direction when it hits certain price points.
Minimise risks: Technical analysis can make you understand the mindset of traders and minimise the risks.
The Technical Analysis Approach
The fundamentals of technical analysis are based on three approaches:
Market action discounts everything
Over a period of time, there are many factors that are priced into the market and are constantly reflected in the prices of stocks and indexes. The variations in the supply and demand equation are influenced over a period of time - from anything economic, political, social, and psychological - those that have happened, are expected to happen and could happen.
These factors could be the emotions of investors to inflation, the reactions of traders to interest-rate data, the sentiments of employees towards important salary or pending earning announcements, etc. This means the prices also reflect the expectations, uncertainties, assumptions and criteria, both rational and irrational, of the many investors out there.
As the market changes, it adjusts along with the prices reflecting that new data. The only data that is not included are natural calamities like massive earthquakes, forest fires, etc.
It is not possible to form a statistical conclusion for these factors; so they are analysed and finally expressed as a closing price at which a transaction is closed. In a nutshell, it can be said that the price includes all the fundamental information available and, at the same time, many other aspects of equal or greater importance.
Prices move in trends
Price moves can happen for days, weeks, months and years, creating a bull market. Likewise, prices can also move down for the same periods, creating a bear market. Even if the direction of a price move (up or down) is as short as a few minutes or as long as years together, it is called a trend, which is one of the most important concepts to the technical approach.
Markets move in trends and investors look to identify and follow trends; the idea of charting the price action of a market is to easily identify trends in the early stages of their development. The trends continue in one direction until changes are produced that can result in differences in the supply and demand equation. This results in a movement in the reverse direction.
A technical analyst has to not only detect a trend in its early stages with the purpose of following its direction but also identify when the trend starts to move in the reverse direction and close the position.
History repeats itself
Technical analysis and human psychology go hand in hand. Chart patterns over the past many years reveal the bullish or bearish psychology of the market. For the same reason that these patterns have worked well in the past, it is assumed that they will continue to work well in the future. Human psychology does not change too much and there are certain patterns of human behaviour in the financial markets that have been catalogued in the past that continue to repeat now and will repeat in the future. This makes it possible to establish that the future movements of the market will be very similar to those that occurred in the past.
For the simple reason that price movements highly influenced by human psychology, it can be considered as being purposeful. Markets can be unpredictable and price movements completely random, but technical analysts have always identified human behaviour patterns by examining past markets. Investors stick to certain habits, which are seldom broken. As a trader, you need to take advantage of this information in order to gain a upper hand over the eventual unpredictability of the market.
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The technical indicators are given below:
- Trends: Trends are used to detect trends in the financial markets and indicate the direction of price movement.
- Momentum: Momentum is used to determine the strength and weakness or rise and fall of an asset. It shows the trend of the prices and the changes it has had in a certain time. Momentum is used to anticipate trend changes.
- Volatility: Volatility is the measure of price variation. This could be the total movement between low and high over some fixed period or an average. Volatility can be measured and calculated on the basis of historical prices, as well as to identify trends. It also indicates whether a market is overbought or oversold and may point to a trend reversal.
- Volume: Volume is used to study the volume of a market, allowing the evolution of volume to be related to changes in the price.
Essential Tools to Conducting Technical Analysis to Charting Cryptocurrencies
Let us take a look at a few indicators that can help traders.
Candlestick charts: Candlestick charts are one of the most effective charts to conduct technical analysis. The candlestick charts display the size of price moves in different colours, green for a positive candle and red for a negative candle. Each candlestick displays four critical components that are used to provide useful information in an easy to read and concise format. They are:
- Open price
- High price
- Low price
- Close price
Support and resistance: Another simple and effective method of conducting technical analysis is to identify areas of support and resistance. In other words, identifying the level where the price tends to find support as it falls and where the price tends to find resistance as it rises.
The market has an interest in buying or selling at a certain price, which creates levels that are difficult to breakthrough.
Trend lines: Another basic technical analysis tool is the trend line. As the name suggests, the idea is to identify a line that represents a trend.
Technical analysts trace the tops or bottoms of candlestick patterns to identify a clear bullish or bearish trend for the price of a cryptocurrency.
Moving averages: Another indicator that helps technical analysts is by analysing data points that create a series of averages - moving averages. There are two types of moving averages:
- Simple moving averages
- Exponential moving averages
While simple moving averages are calculated by adding the recent set of prices, the exponential moving averages tracks price over time.
Relative strength index: Relative Strength Index (RSI) is a momentum indicator that is used to determine the magnitude of recent price changes, i.e., whether or not a cryptocurrency is overbought or oversold.
Bollinger bands: This technical analysis tool helps determines oversold and overbought assets and whether the prices are high or low on a relative basis.
Standard deviation: A widely used risk indicator, standard deviation is a measure of how spread out the prices or returns of an asset are on average.
The Drawbacks of Technical Analysis
A few disadvantages of technical analysis are given below.
Sometimes technical indicators give mixed signals
There are times when one or more of the technical indicators will show a buy signal and another indicator will show a sell signal. This can cause a lot of mix-up in the trading verdicts you make. To avoid more confusion, you should use a combination of technical indicators, patterns, volume, and moving averages to determine the entry and exit point.
Not always accurate
While breakout is powerful, technical analysis is not always correct. No technical indicator is perfect, however, as a beginner, the biggest mistake you can make is attributing too much reliability and accuracy to technical methods.
There are chances that when a possible entry or exit point for a stock is suggested, it doesn’t guarantee a successful trade. Stock may decrease after the entry. Stock can also rise after the exit.
There are chances that one technical analyst’s opinion may contradict another analyst’s opinion for the same stock. The technical methods that are used to analyse stocks can vary from one analyst to another.
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