Technical analysis is an important concept that many day traders and investors use. It is a type of analysis where day traders look at charts, identifies patterns, and makes predictions on what to expect.
Traders also use technical indicators like moving averages, Relative Strength Index (RSI), and the MACD. In this article, we will look at how to conduct an effective technical analysis in the market.
How technical analysis works
The idea behind technical analysis is that financial assets move in unique patterns. As such, identifying these patterns can help you predict the next price action of the asset.
For example, chart patterns like head and shoulders, rising and falling wedges, and double top and bottoms tend to form before an asset reverses.
In addition to these patterns, traders use indicators to identify and confirm trends and reversals. These indicators are created using mathematical calculations. For example, moving averages are calculated by adding values and dividing the periods.
Technical analysis works well when incorporated with fundamental analysis. Fundamental analysis looks at news events and economic data that impact financial assets. For example, quarterly earnings have a major impact on stock movements.
The basis of all analysis: News and Economic Data
Financial instruments move up and down mostly because of financial news and economic data (many traders call it news trading).
Investors and traders use this data to forecast the future situation of the stocks, currencies, indices, futures, and commodities. The use of news and economic data is the most important part of any analysis.
Let us use the example of country A that is undergoing significant economic issues. Its exports are failing and the foreign reserves declining. In the country, there is war and political instability.
Will investors seek to invest in such a country? The answer is no and this is likely to lead to less demand for its currency.
Deal with your emotions
The second most important part of any financial instrument is the emotions among investors.
All investors have some fear amongst themselves. They often don’t know who is buying or who is selling the financial instruments. As a result, the role of emotions is very important.
To learn from the crowd, traders use technical analysis to predict the likely and unlikely scenarios.
How to really perform a technical analysis
We just explain you the background to be a master of technical analysis. Here we want to do a deepening explaining you the best way to perform technical analysis.
To do this, we will use the EUR/USD currency pair.
1. Study the Chart Visually
The first step for any technical analysis is to study the chart visually. This is where you look at the chart and look to understand its movements. You do this by adjusting the chart times.
We recommend you start from a ten-year chart to the 30-minute chart. For active day traders, you can even go down to 5 minutes.
In this step, you simply want to learn how the chart is moving and potentially, why it has moved like that. In this stage, you can also decide to switch between different chart types like candlesticks, renko, line charts, and heikin ashi. These charts will give you more color about the price movement.
Further, as you analyze the chart visually, you should look for unique patterns. Some of the popular candlestick patterns to consider are doji, heikin ashi, hammer, and engulfing.
Also, you should look at other chart patterns like hammer, triangle, head and shoulders, and cup and handle.
2. Draw Support and Resistance Zones
The next step is to draw the support and resistance zones in your favorite chart timeframe. In the chart below, We used our EUR/USD 30-minute chart to draw valuable support and resistance areas.
These are areas the pair is likely to touch or test.
The best way to draw the support and resistance areas is to do it visually. An alternative method which is also good is to use the Fibonacci Retracement.
As shown below, the areas the Fibonacci Retracement tool shows are similar to those we found visually.
As shown in the chart, the Fibonacci Retracement tool identifies the support and resistance levels. What this means is, if there is a reversal, traders should watch out for the Fibonacci Retracement levels.
There are other tools that will help you draw quality support and resistance levels. For example, you can use pivot points, which are mathematical tools that identify S&R levels.
Examples of these pivot points are Woodie, Traditional, and Fibonacci. Other tools that will help you identify support and resistance levels are Andrews Pitchfork, Gann Box, and Gann Fan among others.
3. Apply Technical Indicators
You should take note of the support and resistance levels. We recommend that you either take a screenshot or write them down on a piece of paper.
After using the RSI and MA, we like using the Elliot Wave to forecast the future price movements. In this chart, we drew the pink line to show the area where the pair established a significant support location.
We then used the inbuilt tools to draw the Elliot Waves.
By combining these technical tools, we are able to predict the next movements for the pair.
As shown, the chart is moving low which is expected as the Elliot Wave reversal wave (ABC) starts to take shape. This correction is often short and happens before an upward trend starts to form.
An important concept in technical analysis is known as multi-timeframe analysis. This is a situation where a trader looks at different chart time frames when doing technical analysis.
It is an important process since charts look differently in various timeframes. For example, a chart that is rising on the daily chart might be retreating on the 4-hour chart.
Doing a multi-timeframe analysis will help you in several ways. First, it will help you to identify the real trend of an asset.
Second, multi-time frames are useful in helping you identify support and resistance levels. These levels are useful because you can use them as stop-loss and take-profits. Further, you can use a multi-timeframe to identify potential entry and exit points in an asset.
Deal with emotions
An important concept in technical analysis is dealing with your emotions. At times, a very good technical trader will often make the mistake of not managing their emotions. For example, they will often do the right thigh in technical analysis and then be overcome by their emotions.
For example, these traders could fall victim to several types of biases in trading. The most popular of these are gambler’s fallacy, optimism bias, overconfidence bias, and anchoring bias among others. Having a good trading plan and a trading journal will help you deal with these emotions.
Technical analysis is an important concept that will help you in the financial market. It looks at key details in an asset and helps you identify entry and exit price.
As you will see, mastering technical analysis takes time and effort. But anyone who is dedicated can do it by using online materials and using a demo account.