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PlusMarkets Analysis • 18/03/2021
When discussing ‘technical analysis’, we are referring to a particular method used to detect trading entries and evaluate possible investments. It is conducted through statistical trend analysis gathered from trading activity and historical price fluctuations. Now, let us take a closer look at how exactly it works.
When using technical analysis to evaluate an asset’s perceived value, it considers price and volume. Technical analysis tools recognize how supply and demand for a financial instrument will alter the price, volume, and implied volatility. Trading signals are generated through this analysis of data in the short term, while a security’s strength or weakness in correlation to the broader market is identified, too. Overall, this kind of information will help improve the valuation estimate retrieved by analysts.
If an asset has historical trading data, technical analysis can be applied. That includes futures, stocks, currencies, commodities, and cryptocurrencies, to name a few. This approach can be applied to any kind of security or financial instrument and is therefore particularly popular within forex markets, where traders focus on short-term price movements. Though it ought to be noted that past performance is not an indicator of future results. Likewise, future forecasts are not a dependable indicator of future performance.
The history of technical analysis is derived from hundreds of years of market data, but credit is often bestowed upon Charles Dow for introducing the method in the late 1800s. Dow is the founder of The Wall Street Journal and, most importantly, the Dow Jones Industrial Index. Ultimately, this is what paved the way for technical analysis. He recorded the highs and lows of his average, using this to seek out market movement patterns.
However, he cannot be solely attributed to the creation of technical analysis. Numerous individuals observed the market in similar ways throughout the years. Some aspects can be identified in Joseph de la Vega’s 17th-century accounts of the Dutch financial market. While in Asia, it is noted that Homma Munehisa developed the method in the early 18th century, and this later evolved into the use of candlestick techniques – a technical analysis charting tool key to this very day.
Other noteworthy contributions were made by Edson Gould, Robert Rhea, and William P. Hamilton. Over the years and with additional research, these different approaches evolved to include hundreds of patterns and signals.
Since technical analysis looks to forecast price movement, it is often considered a study of supply and demand forces derived from the market price movements of a security. Though it commonly applies to price changes, some analysts track numbers other than just price – for example, trading volume or open interest figures.
Hundreds of signals and patterns have been developed by analysts to support technical analysis trading. Multiple systems have been created, too, to assist with forecasting and trading on price movements. There are different kinds of indicators – some focus primarily on identifying the current market trend, while others determine the strength of a trend and how likely it is to continue. There are numerous technical indicators and charting patterns but those most commonly used are moving averages, momentum indicators, trendlines, and channels.
Generally speaking, three assumptions are referred to for the technical discipline. Firstly, the market discounts everything, meaning that the company’s fundamentals are already priced into the stock. This point of view is in accordance with the Efficient Markets Hypothesis (EMH), which offers a similar conclusion of price movement. Secondly, price movement occurs in trends and is more likely to follow a pattern than change erratically. Lastly, the price movement has a repetitive quality, which in turn impacts market psychology. This is made easier to predict by traders’ fear and excitement around security.
There are two primary but opposing approaches when it comes to market analysis: fundamental and technical. Though they are both used for researching and forecasting patterns in stock prices, they have their fair share of supporters and opponents.
Fundamental analysis uses the intrinsic value of a stock when evaluating securities. To do so, analysts consider everything from the company’s earnings, economic climate (domestic and global), industry competition, and changing interest rates. Key characteristics that are reviewed include revenues, assets, liabilities, and expenses.
Conversely, technical analysis reviews the price of a stock and its volume. This school of thought maintains that all known fundamentals are factored into the price, and therefore attention need not be paid to them. The intrinsic value of an instrument is not measured by technical analysts. Instead, stock charts are used to pick out trends that indicate what might happen in the future.
As with most methods, technical analysis has its perceived limitations, but identifying signals for price trends in a market is key to any trading strategy. All traders require a methodology for detecting the best entry and exit points in the market, and using technical analysis tools is a particularly popular way of achieving this.
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